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TH
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VOLUME 5
THE OLIVER WYMAN
PERSPECTIVES ON THE RISKS THAT WILL DETERMINE YOUR COMPANY’S FUTURE
RISK JOURNAL
ABOUT THE COVER
On November 10, 1985, the town of Epecuen, in Argentina, was flooded after water broke through the embankment
protecting the town, with water levels eventually reaching 10 meters in height. Three decades later, the water has
receded. But Epecuen remains a ghost town. This photo was taken in 2010.
© Dimaberkut | Dreamstime.com - Dead City In Argentina Photo
Organizations are required to respond to an ever-expanding range of interconnected risks
in order to remain successful. In today’s environment, risk identification and mitigation are
essential elements of firms’ strategies as they face the challenges of economic volatility, falling
commodity prices, rapid technological change, and cyberattacks.
It is our pleasure to share with you the fifth edition of the Oliver Wyman Risk Journal. This collection of
perspectives represents the latest thinking on risk from across our firm.
I hope you find the Oliver Wyman Risk Journal informative and valuable.
Yours sincerely,
INTRODUCTION
Scott McDonald
President & CEO
Oliver Wyman Group
26 BEYOND THE LOSS-LEADER STRATEGYBusiness models based on cross-subsidizing no longer work
Duncan Brewer • George Faigen • Nick Harrison
30 INSURANCE MODEL UNDER THREATA future of compulsory risk sharing?
Fady Khayatt
34 THE NEW BALANCE OF POWER IN OILFrackers are challenging traditional swing producers
Bernhard Hartmann • Rob Jessen • Bob Orr Robert Peterson • Saji Sam
40 MAKING LEMONADE FROM STRESS TESTING LEMONSThe brighter side of the banks’ Comprehensive Capital Assessment and Review program
Michael Duane • Til Schuermann
6 THE ONLY WAY IS UP What a rise in US interest rates could mean for the global economy
Barrie Wilkinson
12 CYBER-RISK MANAGEMENTWhy hackers could cause the next global crisis
Raj Bector • Claus Herbolzheimer • Sandro Melis Robert Parisi
18 CONTROLLING THE GENIE OF EMERGING TECHNOLOGIESSix steps to mitigate risks created by innovation
John Drzik
CONTENTS
EMERGING RISKS REVAMPING BUSINESS MODELS
VOLUME 5, 2015
70 A BANKLESS FUTURE?Bracing for the unbundling of banks
Barrie Wilkinson
76 THE INDUSTRIALIZATION OF COMMODITY TRADING What asset-backed traders’ strong results mean for the future of independent traders
Alexander Franke • Ernst Frankl • Christian Lins Adam Perkins • Roland Rechtsteiner • Graham Sharp
84 COMMERCIAL DRONESThe United States must speed up globally competitive regulations
Georges Aoude • Peter Fuchs • Geoff Murray
88 SELF-DRIVING FREIGHT IN THE FAST LANE Driverless vehicles are about to rewrite the rules for transporting not just passengers, but freight, too
Jason Kuehn • Juergen Reiner
48 REVAMPING RISK CULTURESIt’s time for companies to focus more on behavioral blind spots
Bill Heath • Kevan Jones • Sir Hector Sants Richard Smith-Bingham
54 THREE LINES OF DEFENSE IN FINANCIAL SERVICESFive signs that your firm is living a lie – and what to do about them
Mark Abrahamson • Michelle Daisley Sean McGuire • George Netherton
58 FINES AND FINANCIAL MISDEMEANORSFinancial crime is the new material risk for banks
Dominik Kaefer
62 LIQUIDITY RISKUncovering the hidden cause of corporate shocks
Alexander Franke • Ernst Frankl • Adam Perkins
RETHINKING TACTICS REDEFINING INDUSTRIES
EMERGING RISKS
The Only Way Is Up
Cyber-Risk Management
Controlling the Genie of Emerging Technologies
RISK JOURNAL | VOLUME 5
Central banks responded to the
financial crisis by slashing interest rates.
In August 2007, the United States
federal funds rate was 5.25 percent. By
December 2008, it had fallen to 0.25 percent.
After seven years of sluggish economic
recovery, the rate remains stuck there.
As the US economy picked up in 2014,
pundits predicted a rate rise in 2015. But
these expectations have been confounded
by dramatic declines in prices recently across
a broad range of commodities and stock
indices. Investors fear an accelerated economic
slowdown in China and knock-on effects on
still-weak US and European economies.
Meanwhile the Federal Reserve has been
sending mixed signals about the likely timing
and size of rate rises. Many investors fear that
a premature or overly large rate rise could
be the final nail in the coffin for emerging
market economies.
How worried should investors be? In other
words, how likely is a material rise in US interest
rates and what would it mean for markets?
THE ONLY WAY IS UP WHAT A RISE IN US INTEREST RATES COULD MEAN FOR THE GLOBAL ECONOMY
Barrie Wilkinson
A BRIEF HISTORY OF US INTEREST RATES
To answer the first part of our question, we
need to understand the history of US interest
rates and what drives it.
US interest rates have been declining steadily
since the early 1980s. (See Exhibit 1.) Inflation
is part of the explanation. Before a lender can
earn any real interest, the rate on their loan
must first compensate them for the erosion
of their money’s purchasing power when the
loan is repaid. As inflation has fallen since the
early 1980s, interest rates have automatically
fallen with it. Moreover, the real rate of interest
(the nominal interest rate minus the rate
of inflation), which ultimately influences an
individual’s propensity to save versus spend,
has also fallen.
A rise in US interest rates could spell crisis for
emerging markets
EMERGING RISKS
7
Why have rates been falling?
Judging by media discussion of interest rates,
you might easily believe that real interest rates
are entirely at the discretion of central bankers.
They aren’t. According to Ben Bernanke,
“The Fed’s ability to affect real rates of return,
especially longer-term real rates, is transitory
and limited.”
In fact, the influence works in the other
direction. The Fed aims to set interest at the
so-called “equilibrium” rate. This is the rate at
which borrowing is not so cheap as to cause
“overheating” and consequent inflation, nor
so expensive as to stifle spending and cause
a recession. What this equilibrium rate is
depends on economic circumstances beyond
the control of the Fed.
For the past seven years, spending within
the economy has been low as a result of high
unemployment and the need to pay down
debt built up during the pre-crisis boom. This
depressed the equilibrium rate and required
the Fed to keep rates low. The US now appears
to be re-emerging from this slump, pushing up
the equilibrium rate. The general consensus
is that rates need to rise because the risk of
overheating has started to outweigh the risk of
an economic contraction.
A BIG RISE?
But by how much will interest rates rise?
The general consensus seems to be “not
much.” According to such thinking, the Fed will
gradually raise the fed funds rate to 2 percent
or 3 percent, and even this may prove a brief
RISK JOURNAL | VOLUME 5
8
peak. Structural changes in the economy,
such as an aging population, mean that the
equilibrium rate will continue to remain low
over the long run, limiting the extent of any
upward pressure.
Set against this view, however, is the
evidence of history. As the earlier periods of
Exhibit 1 show, nominal interest rates can
reach extraordinarily high levels and even real
rates can be as high as 8 percent.
Of course, the US economy of the postwar
period, which saw steadily rising nominal
rates, was quite unlike today’s economy. The
fact that real rates remained low during this
period indicates that inflation was the largest
driver of these rises. The Fed now has a much
clearer policy of managing inflation within
a tighter band; and the US is no longer so
exposed to external shocks in energy prices,
so the threat of spiraling inflation is hopefully
limited. The sudden rise in real rates in the
1980s can perhaps be attributed to the baby
boomers of the 1950s and 1960s coming
of age in the workforce, combined with the
liberalization of the economy during the
Reagan era. By contrast, these same baby
boomers are now preparing for retirement,
causing a drag on the economy and a buildup
of the supply of savings that is more likely to
keep real rates low.
But this only suggests that if interest rates
rise, it is unlikely to be for the same reasons
that they rose in these earlier periods. A rise
ExHIBIT 1: DECLINING US BOND YIELDS
TEN-YEAR AND THREE-MONTH US GOVERNMENT BOND YIELDS HAVE BEEN DECLINING SINCE 1984
5
10
15
-5
0
20
1964 1974 1984 1994 2004 2014
YIELD
US three-monthgovernment yields
US 10-year real government yields
US 10-yeargovernment yields
Source: Oliver Wyman analysis; DG ECFIN AMECO; OECD; Thomson Reuters Datastream
Interest rates need to rise because the risk of overheating has
started to outweigh the risk of an economic contraction
EMERGING RISKS
9
in interest rates could very well happen for
some other reason. A profound technological
advance might cause an investment boom. Or
a dramatic increase in immigration might cause
a boom in the housing and education sectors.
Or a rise in rates may be inexplicable, because
economies are complex open systems and,
hence, unpredictable.
When the only way is up, and when history
is full of large shifts, risk managers would be
prudent to consider much larger rate moves.
What could a significant rate rise mean?
Over the past three years, concerns have been
shifting away from the Eurozone peripheral
nations, toward the fragility in emerging
markets economies. (See Exhibit 2.) At
the heart of the problem is the economic
slowdown in China and its knock-on effects.
The reverberations from China’s slowing
economy are being felt most acutely in
commodities-producing nations such as
Brazil and Russia, whose economies can be
viewed as a leveraged bet on China.
If US rates were to rise significantly, capital
would flow out of China and other emerging
markets and back into US assets. To protect
their currencies from further devaluation,
interest rates in emerging markets would
have to rise above their equilibrium rates,
further stifling already slowing growth. A US
interest rate rise is the last thing emerging
market economies now need. But that doesn’t
make it any less likely.
History indicates that the Fed will act solely
in the US interest when setting interest rates.
The big question is whether the emerging
markets crisis will be contained to equity and
property markets or whether it will spread
into corporate debt markets (noting that
many emerging markets corporates have been
borrowing in dollars), potentially infecting the
banking system and ultimately threatening the
solvency of sovereigns.
ExHIBIT 2: GROWING EMERGING-MARKET CONCERNS
EMERGING MARKETS’ CREDIT DEFAULT SWAP (CDS) PRICES ARE RISING, WHILE EUROZONE CDS PRICES ARE STABILIZING
Spain
Italy
Indonesia
Turkey
Brazil
200
100
300
400
0
500
Jan 2012 Jan 2013 Jan 2014 Jan 2015
CREDIT DEFAULT SWAP PRICESPERCENTAGE POINTS
Eurozone crisis
Emergingmarketscrisis?
Source: Oliver Wyman analysis; Thomson Reuters Datastream
RISK JOURNAL | VOLUME 5
10
SWINGS AND ROUNDABOUTS
According to proponents of globalization,
improved economic prospects in one part of
the world should act to benefit the rest of the
global economy. However, the business cycles
of emerging markets and the developed world
are rarely in sync. Arguably the developed
world has not benefited a great deal from
the emerging markets growth story since
capital has fled the developed world to seek
opportunities in the emerging markets. As
the US now recovers, the money will flow in
the other direction, which spells bad news for
emerging markets economies.
Barrie Wilkinson is a London-based partner and co-head of Oliver Wyman’s Finance & Risk practice in Europe, Middle East, and Africa.
EMERGING RISKS
11
CYBER-RISK MANAGEMENT WHY HACKERS COULD CAUSE THE NEXT GLOBAL CRISIS
Raj Bector • Claus Herbolzheimer • Sandro Melis • Robert Parisi
In recent months, cyber terrorists have
accessed the records of 21.5 million
American public service employees,
infiltrated the German parliament’s network,
and blocked a French national television
broadcaster’s 11 television channels for
several hours. Last summer, a malware attack
compromised the operations of more than
1,000 energy companies, giving hackers the
ability to cripple wind turbines, gas pipelines,
and power plants in 84 countries, including
the United States, Spain, France, Italy,
Germany, Turkey, and Poland at the click
of a mouse.
For many years, the world has benefited from
information technology advances that have
improved the productivity of almost every
industry – banking, healthcare, technology,
retail, transportation, and energy. But we
continue to underestimate the dark side of this
equation: Greater dependence on information
technology is resulting in an increasing and
unprecedented number of cyberattacks.
More than 30 countries – including Germany,
Italy, France, the United Kingdom, the
United States, Japan, and Canada – have now
rolled out cybersecurity strategies. Financial
services regulators in the United Kingdom
are working with top banks to improve their
cyber-risk management. Germany is weighing
a cybersecurity law that will require companies
deemed critical to the nation’s infrastructure
to immediately report cyber incidents to the
government. And on June 29, the Latvian
Presidency of the Council of the European
Union reached an understanding with the
European Parliament on the main principles
of what could become a unified cybersecurity
directive for the European Union designed
to protect critical infrastructure.
1,000The estimated number of energy firms that hackers compromised
in a global malware attack in 2014
13
EMERGING RISKS
MOUNTING CYBER THREATS
But the searing reality is that both the growing
strategic relevance of data and the potential
impact of data breaches for companies are
outpacing these initiatives. The most recent
Global Risks report by the World Economic
Forum and its partners (including our firm
Oliver Wyman) ranks cyberattacks as one of the
top 10 risks most likely to cause a global crisis.
The World Energy Council, a forum for energy
ministers and utilities, considers cyber threats
as one of the top five risks to the world’s
energy infrastructure.
That’s because the industrial control systems
that support power utilities, oil and gas
companies, and refiners are more exposed to
external threats now that they increasingly rely
on digital data networks. Digital blockchain
collective ledgers of Bitcoin transactions
and other new technologies are rapidly
multiplying the potential points of intrusion
in global banking systems. Manufacturing
and machinery industries, too, are entering
a new world of cyber product liability and
data protection, as they share production
facilities and introduce more devices
produced elsewhere into their own products.
In response, companies with revenues
of more than $1 billion have increased
their cyber insurance limits worldwide by
42 percent on average since 2012, according
to Marsh Global Analytics estimates.
Marsh, like Oliver Wyman, is a division of
Marsh & McLennan Companies. Over the
same time period, healthcare companies have
bought 178 percent more cyber insurance and
power and utilities firms have expanded their
coverage by 98 percent. (See Exhibit 1.)
RISK JOURNAL | VOLUME 5
14
+178%HEALTHCARELargest coverage increases• Media coverage• Business interruption coverage
+55%ALL OTHERLargest coverage increase• Information asset coverage
+98%POWER AND UTILITIESLargest coverage increases• Media coverage• Information asset coverage• Cyber extortion coverage
+61%RETAIL/WHOLESALELargest coverage increases• Business interruption coverage• Information asset coverage
+4%EDUCATIONLargest coverage increase• Media coverage
+22%FINANCIAL INSTITUTIONSLargest coverage increases• Information asset coverage• Business interruption coverage• Media coverage
+26%COMMUNICATIONS, MEDIA, AND TECHNOLOGYLargest coverage increase• Media coverage
+20%SPORTS, ENTERTAINMENT,AND EVENTSLargest coverage increase• Media coverage
AVERAGE INCREASE
+42%HOSPITALITY AND GAMING
Largest coverage increases• Information asset coverage• Business information
ExHIBIT 1: RISING CYBER RISKSCOMPANIES ARE SPENDING MORE ON CYBER-RISK INSURANCE TO PROTECT THEMSELVES FROM AN INCREASING NUMBER OF CYBERATTACKS
Source: Marsh Global Analytics. Percentage increase in spending by companies with more than $1 billion in revenues on cyber-risk insurance from 2012 through 2014
EMERGING RISKS
15
Former director of the United States’ National
Security Agency, General Keith Alexander, has
commented that countries need something
like an integrated air-defense system for the
energy sector to keep up with mounting cyber
risks. The same is true for other industries. But
recent clashes between the White House and
Republicans over the establishment of a new
Cyber Threat Intelligence Integration Center
demonstrate that marshalling the resources
required to protect companies more broadly
will take time.
TREATING CYBER RISKS AS OPERATIONAL RISKS
So what else can be done? Above all, companies
must treat cyber risks as permanent risks to
their entire enterprise and not as isolated
“information technology” events. Unlike
strategic, operational, and financial risks,
cyber risks are often mistakenly treated as
lower priority and relegated to the information
technology and communications departments.
98%The percentage increase in cyber insurance coverage by power and utilities firms in the past two years
As a result, the true cyber risk exposure of
companies often goes unnoticed by top
management and boards of directors, exposing
companies to greater risk. Cyber risks are rarely
quantified or linked with their potential impact
on companies’ financials, making it almost
impossible to conduct cost-benefit analyses or
make strategic choices. Information-technology
departments introduce new technical solutions
with minimal top-level direction and without
any comprehensive understanding of the
risk appetite of the organization. Companies
adopt case-by-case reactive measures instead
of a balanced portfolio of initiatives that involve
their entire organization and align with their
overall appetite for risk.
Companies, instead, should set a target
level of cybersecurity for critical networks
based on their importance to the firm’s overall
appetite for risk, much as they would with any
other operational risk. This should be done
quantitatively, perhaps in the form of financial
exposure a company is willing to accept. The
company should then ensure that controls and
processes address gaps that are accordingly
prioritized, starting with those that are mission
critical. For example, the potential economic
loss associated with construction plans for a
new, innovative product may be significantly
higher than that of an older production line that
is about to be retired.
MAKING CYBER-RISK MANAGEMENT SECOND NATURETop managers also need to develop a
cyber-risk management culture to the point
that it becomes second nature. Cyber-risk
management goals, such as the protection of
important customer data or the prevention
of unauthorized access to mission-critical
RISK JOURNAL | VOLUME 5
16
Raj Bector is a New York-based partner and Claus Herbolzheimer is a Berlin-based partner in Oliver Wyman’s Strategic IT & Operations practice. Sandro Melis is a Milan-based partner in Oliver Wyman’s Energy practice. Robert Parisi is a New York-based managing director at Marsh.
Marsh, like Oliver Wyman, is a division of Marsh & McLennan Companies.
This story first appeared on BRINK.
systems, should be baked into performance
targets, incentives, regular reporting, and
key executive discussions. When executives
evaluate their tolerance for breaches that could
impact their company’s reputation or violate
health, safety, and environment standards,
cyber incidents involving their industrial
control systems should be front and center.
Otherwise, like other slow-building risks that
people take for granted, ignoring the threat of
increasing cyberattacks could drop unprepared
companies into the middle of a full-blown
crisis. Consider: 81 percent of large businesses
in the United Kingdom suffered a cybersecurity
breach during the past year and the average
cost of breaches has nearly doubled since
2013, according to a recent report produced by
the United Kingdom Department for Business
Innovation & Skills. This isn’t a threat that is
going away. Companies need to do the math
and truly make cybersecurity a top priority.
EMERGING RISKS
17
CONTROLLING THE GENIE OF EMERGING TECHNOLOGIES SIX STEPS TO MITIGATE RISKS CREATED BY INNOVATION
John Drzik
Innovation is vital to progress. Advances
in science, and the new technologies flowing
from them, have propelled economic and
societal development throughout history.
Emerging technologies today have the
potential to further increase global prosperity
and enable us to tackle major challenges.
But innovation also creates new risks.
Understanding the hazards that can stem
from new technologies is critical to avoiding
potentially catastrophic consequences. The
recent wave of cyberattacks exemplifies
how new technologies can be exploited for
malicious ends and create new global threats.
Risk governance needs to keep pace with
scientific advances. (See Exhibit 1.)
What is the next technology innovation
that could create significant new threats?
Synthetic biology and artificial intelligence are
two examples of emerging technologies with
the potential to deliver enormous benefits
but also present significant challenges to
government, industry, and society at large.
Take synthetic biology: Creating new
organisms from DNA building blocks offers
the potential to fight infectious disease, treat
neurological disorders, alleviate food security,
and expand biofuels. The flipside is that the
genetic manipulation of organisms could also
result in significant harm, through error or
terror. The accidental leakage of synthesized
organisms, perhaps in the form of unnatural
microbes or plant mutations, could lead
to unintended consequences, such as the
rise of new diseases or a loss of biodiversity.
Bio-terrorism threats could emerge from
organized groups or lone individuals in the
growing “bio-hacker”community, were they
able to access synthetic biology inventions
online or spread organisms of their own.
We need to set a course for rigorous risk governance of
emerging technologies
THE DOUBLE-EDGED SWORD OF ARTIFICIAL INTELLIGENCE
Artificial intelligence (AI) also presents a
double-edged sword. Advances in AI can
increase economic productivity, but at the
same time, they may also result in large-scale
structural unemployment, leading to serious
social upheaval. AI developments raise new
questions about accountability and liability:
Who is to be held accountable for decisions
made by self-driving cars, in cases where the
choice is between harming a pedestrian versus
a passenger? (See “Self-Driving Freight in the
Fast Lane,” on page 88.)
Similar challenges need to be confronted given
the rapid growth of unmanned aircraft systems
(or drones). (See “Commercial Drones,” on
page 84.) Looking into the future, some have
even posited that the achievement of “the
Singularity,” the point at which machine brains
surpass human intelligence, would present an
existential threat to humanity.
Risk governance for these and other emerging
technologies is challenging. Many institutions
and communities are engaged in research and
development, and the pace of innovation is
accelerating. National legal and regulatory
frameworks are underdeveloped, so certain
topics and techniques escape scrutiny by not
EMERGING RISKS
19
ExHIBIT 1: GLOBAL RISKS LANDSCAPE 2015
THE POTENTIAL IMPACT AND LIKELIHOOD OF GLOBAL RISKS OVER THE NExT 10 YEARS
For the Global Risks 2015 report (published by the World Economic Forum in collaboration with a group of partner organizations, including Marsh & McLennan Companies), 900 risk experts representing business, government, non-governmental organizations, research institutions, and the academic community selected, out of a group of 28 global risks, the ones that will be of greatest concern over the next 10 years. These pages summarize the results.
On the left lies the full gamut of risks. Note that three technological risks – cyberattacks, data fraud or theft, and critical information infrastructure breakdown – are among those considered to be of greatest concern.
Likelihood
Imp
act
4.5
5.0
6.0
5.5
5.55.0
4.0
4.0 4.5
Unmanageableinflation
Unemploymentor underemployment
Fiscal crises
Failure of critical infrastructure
Energy price shock
Deflation
Asset bubbleFailure of financial
mechanism or institution
Natural catastrophes
Man-made environmentalcatastrophes
Failure of climate-change
adaptation
Biodiversity loss andecosystem collapse
Extremeweather events
Failure of urban planning
Weapons ofmass destruction
Terroristattacks
State collapseor crisis
Interstate conflict
Failure ofnational governance
Water crisesSpread ofinfectious diseases
Profound social instability
Large-scaleinvoluntary migration
Food crises
Misuse oftechnologies
Data fraudor theft
Cyberattacks
Critical informationinfrastructure breakdown
Economic Risks
Environmental Risks
Geopolitical Risks
Societal Risks
Technological Risks
Source: Global Risks 2015: Tenth edition, World Economic Forum and partners, including Marsh & McLennan Companies. Oliver Wyman is a division of Marsh & McLennan Companies
RISK JOURNAL | VOLUME 5
20
GLOBAL RISKS BY CATEGORY
Likelihood
ECONOMIC RISKS
GEOPOLITICAL RISKS
ENVIRONMENTAL RISKS
SOCIETAL RISKS
TECHNOLOGICAL RISKS
5.0
5.5
4.5
4.0
4.0 5.04.5 5.5 6.0
4.0 5.04.5 5.5 6.0
Imp
act
Likelihood
5.5
Imp
act
Likelihood
4.0 5.04.5 5.5 6.0
4.0 5.04.5 5.5 6.0
4.0 5.04.5 5.5 6.0
Likelihood
Likelihood
Imp
act
5.0
5.5
4.5
4.0
5.0
4.0
5.0
5.5
4.54.5
5.5
5.0
4.0
4.5
4.0
Imp
act
Imp
act
Failure of financial mechanism or institution
Fiscal crises
Asset bubble
Energy price shock
Deflation
Unemployment orunderemployment
Failure of critical infrastructure
Unmanageableinflation
Extreme weather events
Natural catastrophes
Man-made environmental catastrophes
Biodiversity lossand ecosystem collapse
Failure of climate-changeadaption
Failure of nationalgovernance
State collapse or crisis
Terrorist attacks
Weapons ofmass destruction
Interstate conflict
Failure of urban planning
Water crises
Food crises Profound socialinstability
Large-scaleinvoluntary migration
Spread ofinfectious diseases
Data fraudor theftMisuse of
technologies
Critical informationinfrastructure breakdown
Cyberattacks
Economic Risks
Environmental Risks
Geopolitical Risks
Societal Risks
Technological Risks
Source: Global Risks 2015: Tenth edition, World Economic Forum and partners, including Marsh & McLennan Companies. Oliver Wyman is a division of Marsh & McLennan Companies
EMERGING RISKS
21
being specified. Institutions that are meant
to provide oversight struggle to cope with
advances that cross departmental jurisdictions
and, short on resources, are often unable to
assess risks with the rigor they demand.
At the international level, weaknesses also
exist. For example, the Cartagena Protocol on
Biosafety provides guidelines on the handling
and transportation of living modified organisms,
but not their development. The United Nations
Convention on Biological Diversity addresses
synthetic biology, but the resulting agreement
is not legally binding. A current live concern
is that large-scale international negotiations
such as the Transatlantic Trade and Investment
Partnership (TTIP) may inhibit new governance
proposals and influence global norms
in pursuit of open markets and more
streamlined regulation.
A WAY FORWARD
Is there a way forward, and if so, what is it?
Realizing potential benefits from emerging
technologies requires a willingness to accept
risk. But this risk must also be managed,
to avert disasters. Governance and control
frameworks need to be reinvigorated,
and accountability needs to be clearer.
I recommend six actions:
RISK JOURNAL | VOLUME 5
22
1. As emerging technologies affect
more people than just the users of the
technology, we need a more energetic
dialogue around risk governance priorities
that involves a broad range of stakeholders.
Innovators, industry more broadly,
governments, regulators, and the public
must all be consulted to create greater
buy-in and better considered regulation.
2. Research related to risk governance
needs to be given a higher priority and
more funding. Institutions responsible for
oversight must have the capacity to explore
areas of concern more deeply and to be able
to engage effectively with innovators.
3. Broader disclosure standards are crucial to
allow deeper risk assessment, determine
controls, and build trust. We need to find
the right balance between confidentiality
and transparency. Intellectual property
rights should not be used to restrict access
to information needed for appropriate
risk regulation. Producers should be more
transparent, so that regulators can prepare
effective regulation. Regulators should also
be transparent, so that developers know as
early as possible which kinds of applications
will be prohibited.
4. We need to close regulatory gaps in those
areas that present the greatest risk, and
set out clear compliance and liability
expectations. At the same time, regulation
should become more adaptable to new
developments. Regulatory systems should
build in more intelligent decision gateways
and evolve in the light of new knowledge or
technological advances, which may lower
risk in some areas and increase it in others.
5. International discussions between governing
institutions need to move beyond principles
to more binding protocols. This is critical for
preventing the flow of emerging technology
risks across borders, which is all too easy in
today’s global economy.
6. At the same time as we improve
regulation, we need to promote a culture
of responsibility around innovation – to
encourage more self-policing among
innovators and de-glamorize hackers.
Deep commitment from the sector will
help build and maintain a platform of trust
vital for achieving the potential of scientific
and technological advances.
Innovation must be encouraged, but we
need to set a parallel course for rigorous
risk governance of emerging technologies.
It is much better to confront difficult issues
now than endure an incident with disastrous
consequences later. As we know all too well,
history is littered with risk mitigation measures
that proved ineffective because they were put
in place too late.
John Drzik is President of Global Risks and Specialties at Marsh. Marsh, like Oliver Wyman, is a division of the Marsh & McLennan Companies, which contributed to the World Economic Forum’s Global Risks 2015 report.
This story is adapted from a version that first appeared on the World Economic Forum’s blog.
Understanding the hazards that can stem from new technologies is critical
EMERGING RISKS
23
REVAMPING BUSINESS MODELS
Beyond the Loss-Leader Strategy
Insurance Model Under Threat
The New Balance of Power in Oil
Making Lemonade from Stress Testing Lemons
RISK JOURNAL | VOLUME 5
BEYOND THE LOSS-LEADER STRATEGY BUSINESS MODELS BASED ON CROSS-SUBSIDIZING NO LONGER WORK
Duncan Brewer • George Faigen • Nick Harrison
Many companies selling goods and
services to consumers follow a
decades-old formula: They offer
blockbuster deals on frequently bought
products to grab the attention of price-sensitive
consumers, and make up for the resulting
losses by charging higher prices on other
products or services that are purchased less
often or are harder to compare. Grocery stores
recoup the cost of low prices on milk, bread,
and bananas by selling higher-margin items
like health and beauty products. Banks offer
free current accounts as a way to make more
money from loans and insurance. Electronics
retailers sell cheap televisions to boost profits
from cable, mount, and installation service sales.
This loss-leader strategy has been the bedrock
for many successful businesses. However, the
business model has developed a fatal flaw: It
assumes that consumers primarily purchase
from one provider at a time when the Internet
has made it much easier for consumers to
find individual products at the right price by
visiting multiple websites or online aggregators.
As a result, more consumers now tease apart
their purchases, wrecking the foundation of
loss-leader tactics.
There are many well-known instances of
businesses in various industries being
blindsided by this online threat. Low-cost
airlines and online booking aggregators have
wreaked havoc with package holiday providers
by helping consumers disaggregate their travel
purchases. Online retailers are devastating
electronics players by forcing them to lower
prices not only on headline items but also on
high-margin add-on items.
Now, more businesses in other industries
have come under attack. In the past four
years, more people have started to shop at
multiple grocery stores and websites to get
the best prices. Amazon and specialists like
Wag.com steal away customers by selling
high-volume consumer products such as
pet food for about a third less than in many
grocery stores. Discounters such as Aldi and
Lidl push lower-priced foodstuffs. Peer-to-peer
lenders undercut retail banks by offering loan
and savings products at more attractive rates,
leaving banks to sell more of the lower profit,
transactional products, such as checking and
savings accounts.
In this environment, companies relying on
cross-subsidizing inevitably suffer slow but
irreversible profitability declines. They must
stop such disruptors from cherry-picking their
highest-margin products and customers. The
traditional loss-leader formula is failing. It must
either be forsaken or refined.
A REALISTIC ROUTE TO PROFITABILITY
In order to reduce interdependence between
transactions and to stop rivals from taking away
high-margin business lines and customers,
companies must strengthen their defenses on
highly profitable products and customers
while cutting the resources they devote to
less profitable product segments. They must
examine if high prices charged in some areas
subsidize other parts of their business, and
reduce those subsidies. At the same time,
companies need to raise prices for low-value
23%The percentage increase since
2010 of shoppers who visit multiple stores and websites to
find the best prices for groceries
REVAMPING BUSINESS MODELS
27
customers to reduce cross-subsidies, even if
it means reducing overall market share.
That’s a tall order. For starters, most
companies’ top-level numbers – such as
sales volumes and profit margins – do not
provide the granularity needed for them to
understand if their most profitable products
are at risk. Warning signs can be very subtle:
A small decline in a highly profitable category
could indicate a benign change in consumer
behavior – or it can portend a big shift of
profitable customers to a competitor.
But it can be done. Some companies are
already improving their ability to identify if
high-margin products and customers are at
risk. For example, one grocery store quickly
discovered a competitor stealing away some
of its high-margin razor and blade sales by
broadening the scope of its sales analyses to
include lower-margin related items. Even though
razor sales were sliding, it found that shaving
foams and gel sales remained constant – the
tell-tale sign of a disruption in progress.
ExHIBIT 1: REDUCING LOSS-LEADERS IN A $1 BILLION SERVICE PROVIDER
HOW A SERVICE PROVIDER REDUCED THE PROPORTION OF UNPROFITABLE CUSTOMERS AND INCREASED AVERAGE PROFITABILITY
How a service provider reduced the propotrtion of unprofitable customers and increased aver
CUSTOMER COUNT
LOSS
PROFIT PERCUSTOMER
Lowering prices here made customers more loyal and incentivized new customers to join
Overall, the same number of customers bought the product, but more of the customers were profitable
These customers left the business due to price increase
9%: the profit increase from removing loss-leading customers
Customer mix after churn fromsegmented repricing
Customer mix with standardized pricing for every customer
Source: Oliver Wyman analysis
THINK LIKE A DISRUPTORAfter identifying the problem, companies
must assess which products they would target
if they were a disruptor with detailed inside
knowledge of their core business – and then
act quickly to do something about it.
For some businesses, this mindset is already
second nature. For example, innovative
technology companies will constantly disrupt
their own product lifecycles by introducing
new products even when their current product
line remains profitable. They know that they
must disrupt their own sales; otherwise,
competitors will do it for them.
Now, other companies are following
suit. For example, banks are trying
to fend off peer-to-peer lenders by
building their own platforms or striking
up partnerships – such as Metro Bank’s
recent tie-up with the peer-to-peer lender
Zopa. Grocery store Tesco offers its own
AmazonPrime-style subscription service
RISK JOURNAL | VOLUME 5
28
called Tescosubsciptions.com, which undercuts
prices in its stores on certain high-margin,
easy-to-ship items.
At the same time, businesses are de-incentivizing
and driving away unprofitable customers. One
service company struggling to maintain the
margins of its repair and warranty business
asked certain customers to pay higher prices
after analyses showed that they were likely to
cost more than other customers to serve over
multiple years. While it made profits from the
sales to most of its warranty customers, a few
were dragging down margins by requesting
more than six repairs per year. The company
restored its business profits by tailoring its
pricing to reflect each individual’s long-term
value. Customers with high so-called lifetime
values could buy products at lower prices,
while those with low customer lifetime values
were charged more. The result: The proportion
of unprofitable customers was halved and the
business’ margins improved by over 9 percent.
(See Exhibit 1.)
Duncan Brewer is London-based principal in Oliver Wyman’s Retail and Consumer Goods practice. George Faigen is a Princeton-based partner in Oliver Wyman’s OW Labs practice. Nick Harrison is a London-based partner and co-head of Oliver Wyman’s Retail and Consumer Goods practice in Europe, Middle East, and Africa.
MAKE TOP CUSTOMERS YOUR PRIORITY
Strategies based on cross-subsidizing are
unsustainable in a digital, price-sensitive world
in which customers pick and choose what they
buy and where. New entrants will likely steal
away high-margin products and customers,
undermining incumbents’ business models. To
fend off these threats, companies must hone
their own best product offers and treat top
customers as a high priority.
Cutting prices and offering better services
for profitable products and customers can
be painful and difficult to justify, especially if
a company identifies an online threat in an
early, nascent stage. But waiting can be fatal.
Reducing profits today can often be the only
way to protect a business for tomorrow. In the
long run, experience has shown that the value
of retaining the best customers can more than
offset short-term pain.
REVAMPING BUSINESS MODELS
29
INSURANCE MODEL UNDER THREAT A FUTURE OF COMPULSORY RISK SHARING?
Fady Khayatt
Insurance is made possible through
the pooling of risk. No one knows for certain
whether or not they will be in a serious car
accident in the coming year. Nor can other
drivers predict whether they will have
accidents. What can be predicted is that, say,
1 percent of all drivers will be in accidents. If
enough drivers contribute 1 percent of the
value of their cars into a fund that promises
to pay for the replacement of cars written off
in those accidents, then the fund will have
enough money to pay for all claims on it for a
year. By pooling risks, they can be converted
into predictable ongoing expenses – insurance
premiums, in other words.
Risk pooling is of great economic and social
importance. Most valuable activities entail
risk, from international trade to building power
stations to performing surgery to playing
rugby. If people could not insure themselves
against the risks involved in such societally
beneficial activities, then they would engage
in those activities much less frequently and
society would be much the poorer.
Yet risk pooling via insurance is under threat,
for the apparently perverse reason that insurers
are rapidly getting better at measuring risk.
Here’s why.
Some insurees are riskier than others. Jack’s
chance of smashing his car might be twice Jill’s.
If the insurer cannot identify this difference,
it will charge Jack and Jill the same premium.
This means Jill pays for more than her share of
the risk she contributes to the pool, while Jack
pays for less. In other words, Jill’s premiums will
subsidize Jack’s insurance.
If, however, the difference between the risk
presented by Jack and by Jill can be determined
and quantified, then the cross-subsidy will soon
disappear. Even if their insurer were to decide
nevertheless to charge Jack and Jill the same
premium, Jill will soon be “cherry picked” by
Risk pooling via insurance is under threat, for the apparently
perverse reason that insurers are rapidly getting better
at measuring risk
a competitor charging low-risk drivers lower
premiums. Without Jill’s inflated premium
available to subsidize Jack’s, he will have to
bear the full cost of the risk he represents.
MORE ACCURATE RISK MEASUREMENT
Accurate risk measurement thus eliminates
cross subsidies. And risk measurement is
swiftly becoming more accurate.
Telematics, though hardly new, provides a good
example. Devices installed in cars send insurers
information about their policyholders’ driving
behavior and patterns and, thus, their chances
of getting into an accident. Safe drivers end up
paying lower premiums than risky drivers.
Telematics is but one example of the
burgeoning “Internet of things.” Homes and
commercial assets are increasingly being fitted
with sensors that can provide insurers with
detailed real-time information about insured
objects and their environments.
Nor is this explosion of monitoring and
quantification restricted to objects. People are
collecting far more data about themselves – for
example, about their health – which many are
keen to share with insurers in return for lower
REVAMPING BUSINESS MODELS
31
premiums. Big Data analysis, by drawing on
policyholders’ Internet footprints, is able to
paint an increasingly accurate picture of their
circumstances and behavior.
Insurance pricing that accurately reflects the
risk presented by individual policyholders has
social benefits. In most cases, it incentivizes
people to take actions that reduce risk, provided
such actions cost less than what is saved on
premiums. And they discourage activities that
are not worth the cost when risk is properly
accounted for. In other words, accurate risk
pricing promotes economic efficiency.
THE DOWNSIDE TO ACCURATE RISK PRICING
But greater accuracy in pricing risk has
its downside, too. Some people can find
themselves suddenly priced out of an
insurance market. Homes in areas that are
prone to flooding, for example, may face
premiums so high that they become effectively
uninsurable. Or people predisposed to serious
diseases may face health insurance premiums
they cannot realistically afford.
By making segments of the population
effectively uninsurable, accurate risk-based
pricing removes the benefit of risk pooling
from precisely those who need it most.
How then can affordable insurance be made
available to high-risk populations?
One approach that is increasingly being
applied to the industry is to force low
risk policyholders to subsidize high-risk
policyholders. For example, after a spate
of floods in England, the government of the
United Kingdom will require insurers to
provide flood insurance at capped premiums
and has established a re-insurance fund
(Flood Re) into which all home insurees must
make the same contribution, regardless of
flood risk. (See Exhibit 1.)
ExHIBIT 1: MOVING TOWARD MANDATORY POOLING
THE INSURANCE INDUSTRY IS MOVING TOWARD MANDATORY POOLING TO COPE WITH THE UNINSURABLE POPULATIONS CREATED BY MORE ACCURATE PRICING. BUT AS THE MANDATORY POOL GROWS, THERE IS LESS PRICE DIFFERENTIATION. HERE’S HOW IT WORKS:
INSURANCE IS MADE POSSIBLE THROUGH RISK POOLING
COMPULSORY RISK SHARING
RISK SEGMENTATIONBEGINS
ENFORCED POOLINGBEGINS
Some insurees’ risks are higher than others, but they have traditionally paid similar premiums.
As insurers have become better at measuring risks, they are charging diverging premiums – creating an “uninsurable” population in the process.
Enforced pooling ensures that affordable insurance can still be provided to “uninsurable” populations, but it requires non-affected insurees to pay a larger premium.
Source: Oliver Wyman analysis
RISK JOURNAL | VOLUME 5
32
The difficulty with this approach lies in forcing
low-risk insurees to remain in the pool. In the
case of flooding, the small ratio of high-risk to
low-risk homes makes the now transparent
cross-subsidy small. However, in other
areas, such as health insurance, mandated
cross-subsidies may be large enough to drive
low-risk insurees out of the pool. ObamaCare
deals with this problem by imposing a fine on
anyone who refuses to buy health insurance
equal to 2 percent of his or her income.
Government policies that require people to
buy insurance may look like a boon for the
industry. But they could profoundly change
the insurance business.
POTENTIAL OUTCOMES
When low-risk insurees are forced into
insurance pools with high-risk individuals,
their policies receive an implicit government
guarantee. If the government makes you buy
insurance policies, it must stand behind them.
Insurers may end up in the position that banks
now find themselves – not proper businesses
but quasi-state utilities, where everything
is under indirect political control, from risk
management to pricing to staff bonuses.
Furthermore, where cross-subsidization is
enforced across very large proportions of
the population, capabilities in terms of risk
selection and pricing that insurers have
invested in so heavily become worthless,
leaving insurers to compete on service and
cost efficiency.
Insurers might argue quite correctly that
mandated cross-subsidies place an unfair
burden on low-risk insurees. Why should a less
affluent woman living in an area not prone to
flooding be made to subsidize the insurance
of a wealthy man who has built a mansion on
a floodplain? Why should a struggling healthy
young musician subsidize the health insurance
of a retired banker?
Targeted subsidies funded from general
taxation might be a fairer way of keeping
high-risk people in the pool. And it would
allow insurers to remain independent,
commercial businesses.
Rapidly rising risk and price differentiation
raises a policy issue that must be answered. If
insurers cannot come up with a good answer
on their own, politicians may come up with a
bad one for them.
Fady Khayatt is a Paris-based partner in Oliver Wyman’s Financial Services practice.
REVAMPING BUSINESS MODELS
33
Abdalla Salem el-Badri, secretary
general of the Organization of
Petroleum Exporting Countries
(OPEC), said in April 2015 that the cartel’s
decision to continue to pump oil in spite
of collapsing prices is inflicting pain on
United States shale producers. Six months
later in its September monthly oil-market
report, OPEC wrote: “All eyes are on how
quickly US [oil] production falls.”
North American oil producers are
experiencing widespread pain as a result of
rock-bottom oil prices. One after another,
US-based independent oil producers such as
EOG Resources Inc., Carrizo Oil & Gas Inc.,
Rosetta Resources (now part of Noble Energy),
and Whiting Petroleum Corp. have reported
missed-earnings estimates and plans to
cut production.
Many may need to contract even further.
Banks re-examining their portfolios may
charge them higher interest rates if shale
producers’ credit ratings are downgraded,
which will lower their cash flows. In addition,
the recent hemorrhaging of talent and
equipment at oil field-services companies
could make it more difficult for North American
shale producers to “turn on” additional drilling
and pressure pumping. Consider: At present,
they have only half as many rigs at their disposal
as they did in 2014.
But it’s way too early to count US-based shale
producers out as major players in the oil
markets in the future. Rather, what’s happening
marks an historic shift in the companies acting
as market-driven swing producers by reacting
swiftly to falling prices.
THE NEW BALANCE OF POWER IN OIL FRACKERS ARE CHALLENGING TRADITIONAL SWING PRODUCERS
Bernhard Hartmann • Rob Jessen • Bob Orr Robert Peterson • Saji Sam
The gap is closing between the United States’ crude oil production
and that of the world’s other two top producing countries,
Russia and Saudi Arabia
REVAMPING BUSINESS MODELS
35
AN HISTORIC SHIFTOver the past six years, “tight” oil, also
known as shale oil, has soared from about
10 percent of total US crude oil production to
approximately 50 percent. That means the
US oil industry is producing roughly 4 million
more barrels of crude oil every day than it did
in 2008, according to the Energy Information
Administration (EIA).
As a result, the gap is closing between US
crude oil production and the world’s other
two top producing countries, Russia and
Saudi Arabia. From 2009 to 2014, Russia
grew its production from 9.5 million barrels
per day to 10.1 million, while Saudi Arabia
expanded its production from 8.2 million to
9.7 million barrels per day. Meanwhile, US
daily oil production soared by more than
60 percent, from 5.4 million barrels per
day to 8.7 million barrels. Together, these
three top producers now account for almost
37 percent of the world’s total crude oil
production. (See Exhibit 1.)
The EIA expects the new status quo to
continue. In the first six months of 2015,
US monthly crude oil production ranged from
a high in April of 9.6 million barrels per day to
9.3 million barrels per day in June. The agency
believes that US production will average
9.2 million barrels per day this year and fall
to 8.8 million barrels per day next year,
assuming the “lower for longer” pricing
environment continues.
STRONGER RESILIENCE
The main reason that shale producers are
proving to be resilient is that they have
continuously improved their drilling and
fracturing technology, increasing their drilling
efficiencies and stretching their capital
expenditures. Our research shows that over
the past three years alone, many American
ExHIBIT 1: THE DRAMATIC RISE OF AMERICAN OIL
GREATER AMOUNTS OF SHALE OIL ARE BOOSTING CRUDE OIL PRODUCTION IN THE UNITED STATES…
0 10 8 6 4 2
MILLIONS OF BARRELS PER DAY
2010
2011
2012
2013
2009
2008
2014
… PUTTING IT ON PAR WITH THE WORLD’S OTHER TOP PRODUCERS, RUSSIA AND SAUDI ARABIA
Russia
Saudi Arabia
Iran
Canada
Iraq
China
United States
0
12
8
4
2009 20122010 2011 20142013
32% 34%32% 33% 37%36%
MILLIONS OF BARRELS PER DAY
Top 3 producers percent of total oil production per year
Total US crude production
Total tight oil production
Source: EIA, Oliver Wyman analysis
Source: EIA, Oliver Wyman analysis
RISK JOURNAL | VOLUME 5
36
shale producers have cut their unconventional
oil drilling and completion costs by 15 percent to
25 percent on average. In fact, North American
shale producers are already working toward
reducing their break-even point by as much as
half. A lower break-even point could put shale
on par with the oil fields of many national
oil companies.
Many North American shale producers have
also exercised much greater discipline in
managing operating expenses, recalibrating oil
drilling activity with cash flows and planning for
the “lower for longer” oil-pricing environment.
Leaders in the industry have developed vast
portfolios of operations, which enable them
to cut back on drilling in high-cost areas
while ramping up their drilling in lower-cost
fields. They have also hedged portions of their
production at much higher prices so that they
can still make a financial profit even when their
variable costs exceed the market price.
By contrast, the cost of drilling oil in the
Middle East is starting to climb. To maintain
or improve production from maturing fields,
Middle Eastern national oil companies will need
to adopt enhanced recovery methods using
more expensive technologies. They also will
have to consider tapping into new reservoirs
and fields, many of which are of a lower quality.
It will likely cost more to produce a barrel of oil
from these sourer, heavier, and tighter supplies.
So in effect, as OPEC acts less like a traditional
“swing producer,” North American shale
producers are stepping into the role. Since
1973, Saudi Arabia and other OPEC members
have acted as swing producers by increasing
or reducing their oil output to help the global
market adjust to shortages or surpluses in
supply and volatile prices. North American shale
producers are now responding to market supply
and price changes.
Although some producers are unable to
financially withstand the continued “lower
for longer” oil price environment, most
unconventional producers are proactively
adjusting their production and cost profiles
until prices rebound to more desirable levels.
By allowing their producing shale fields to
deplete naturally and curtailing drilling of new
development wells, they are slashing their
production in response to oversupply and
low prices. But once supply tightens and the
price of oil recovers, North American shale
producers can quickly ramp up production
in a matter of months, rather than years,
by deploying currently demobilized rigs in
factory-mode drilling.
REVAMPING BUSINESS MODELS
37
40
Wolfcamp(Delaware)
0
80
Wolfcamp(Midland)
Eagle FordCondensate
Bakken-ND Eagle FordOil
Niobrara-Wattenberg
2013
2012
2014
… SERVING AS A BLUEPRINT FOR MORE POTENTIAL SHALE PRODUCTION WORLDWIDE
TECHNICALLY RECOVERABLE UNCONVENTIONAL OIL AND GAS RESOURCESIN BILLIONS OF BARRELS OF OIL EQUIVALENT, 2013
Countries with significant potential for unconventional oil and gas recovery
NORTH AMERICAN SHALE PRODUCERS ARE BECOMING MORE EFFICIENT…
Russia
China
Australia
Brazil
Libya
Saudi Arabia*
United States
Canada
Argentina
Venezuela
Mexico
South Africa
Algeria
Europe
Pakistan
US SHALE BREAK-EVEN COSTS, $ PER BARREL OF OIL EQUIVALENTSPOT WTI CRUDE OIL PRICE
JUN 2014$103
200
10025
DEC 2014$69JUN 2015$58
Unconventional oil
Unconventional gas
1,586 Total billions of barrels of oil equivalent
3451,241
ExHIBIT 2: THE GLOBAL RISE OF SHALE PRODUCTION
Sources: EIA, NDIC, IEA, ConocoPhillips investor presentation, Oliver Wyman analysis *The Kingdom of Saudi Arabia has more than 6 trillion cubic square feet of unconventional oil and gas resources, according to oil field service companies operating there.
RISK JOURNAL | VOLUME 5
38
Bernhard Hartmann is a Dubai-based partner, Rob Jessen is a Houston-based partner, Bob Orr is a Houston-based partner, Robert Peterson is a Houston-based partner, and Saji Sam is a Dubai-based partner in Oliver Wyman’s Energy practice.
ExPANDING RANKSWithin the next decade, more unconventional
oil and gas producers may also join existing
players’ ranks. Shortages in rapidly growing
regions such as Asia and Africa are likely to
be further exacerbated by a rising number of
countries taking unilateral action to cope with
local scarcities. And the US has shown one
relatively inexpensive and fast way for countries
to seek energy independence is by exploiting
their own unconventional oil and gas resources.
Until now, the US has dominated the
unconventional oil and gas market in large part
because its players have better access to cheap
capital, stronger mineral rights laws, availability
of water for fracking, and an entrepreneurial,
market-driven supply-chain ecosystem.
So far, no other country has been able to
replicate these conditions successfully. But in
time, countries such as Argentina, Russia,
and China could figure out how to improve
their environments for unconventional oil and
gas drilling – potentially resulting in more
regionalized oil markets in the long term. The
estimated 156 billion barrels of oil equivalent
unconventional resources in the US are only a
small fraction of the approximately 1.6 trillion
barrels of unconventional oil and gas that exist
worldwide. (See Exhibit 2.)
So what steps should governments, national
oil companies, and oil majors take to stay
ahead of these shifts? Most are tightening
their belts to survive currently low oil prices by
eliminating less valuable capital expenditures,
renegotiating supplier contracts, and
reconsidering stock buybacks and dividend
payouts, which have exceeded the oil majors’
cash flows in recent years. Some are also
opportunistically revamping their portfolios of
businesses, workforces, supply chains, and risk
management practices.
BECOMING NIMBLE
While these are practical short-term steps,
the answer to sustaining in a lower oil price
environment is to be nimble, flexible, and
efficient in responding to supply-demand
dynamics. To come out on top, governments
and companies should take advantage of
market distress while they can by rebalancing
their resources to better meet shifting domestic
and overseas demand and supply dynamics
before the economic cycle reverses.
Governments in the Middle East, especially,
should learn from the processes, organization,
supply chains, and other capabilities developed
by North American shale players. They need
to improve their ability to deploy capital in
initiatives that will maximize their localization
by creating more jobs, while expanding their
range of substitutes for energy imports and
potential exports. They should pick up the
acreage, technology, talent, and capabilities
they need to compete in an oil market made up
of many more nimble shale producers.
Frackers are showing that a new, more
market-driven, invisible hand is not influencing
oil prices but, rather, being driven by them.
REVAMPING BUSINESS MODELS
39
MAKING LEMONADE FROM STRESS TESTING LEMONS THE BRIGHTER SIDE OF THE BANKS’ COMPREHENSIVE CAPITAL ASSESSMENT AND REVIEW PROGRAM
Michael Duane • Til Schuermann
Executive dining rooms and cafeterias
at banks across the United States are
all abuzz with talk about the cost and
burden of post-crisis regulatory demands.
But few regulations have left a more sour
taste than the Federal Reserve’s demanding
Comprehensive Capital Assessment and
Review (CCAR) program – or stress testing,
as it’s more commonly called.
JPMorgan Chase’s Chief Executive Officer
Jamie Dimon, in his 2014 letter to shareholders,
noted more than 500 bank professionals (and
thousands of additional contributors) were
dedicated to the 2014 submission, which was
more than 5,000 pages long. The following
year, those numbers ballooned to more than
950 people, and the submission exceeded
20,000 pages. Citigroup, in its third quarter
2014 earnings call, informed investors that it
was spending an incremental $150 million to
$175 million on improving its capital planning
capabilities in 2014 alone.
Is this money spent just for regulatory
compliance? Yes, satisfying the regulations
is necessary, but surely one can make good
economic and profitable use of the machinery
and processes that have been laboriously built
up. How can banks use stress testing for offense
rather than just for defense and compliance?
To make progress in thinking creatively about
the stress testing and the CCAR machine, a
very short overview is in order. Each year, the
largest banks have to go through a capital
planning exercise. Will the proposed capital
plan, which is closely tied to the firm’s strategic
REVAMPING BUSINESS MODELS
41
Banks should and can use stress testing for offense
rather than just for defense
plan (more on that later), survive some really
stressful economic and market conditions?
If yes, and if the Federal Reserve feels
comfortable with the associated risk and capital
management, as well as many other processes,
then the bank passes the test – and the capital
plan, which may contain dividend increases,
share-repurchase programs, and even the
possibility of inorganic growth, as for example
through an acquisition, is approved, or in the
tortured language of the Federal Reserve, “not
objected to.”
To pull this off, banks have built modeling
machinery, which allows them to forecast
bank financials – balance sheet and income
statement, regulatory ratios – under a range
of stressful economic environments. No
small feat!
RIGOROUS BUDGETING
The careful reader will likely have noticed
that, if you can forecast bank financials
under stressful conditions, then surely you
can forecast them in expected or baseline
conditions. Indeed, banks do just that
because they are required also to submit
baseline projections to their supervisors – in
other words, what the banks actually expect
to happen.
Indeed, this is not a new exercise, and it is
something corporations have done throughout
their existence: It’s called a budget, but it is
unlike any budget ever generated in the past. It
is far more rigorous, supported with empirical
analysis, and, importantly, helps separate the
return that comes from the economy and the
market, and the return that is delivered by the
RISK JOURNAL | VOLUME 5
42
bank’s management. Any asset manager of
course will recognize this exercise immediately:
It is the process of separating “beta” (what the
market gives you) from “alpha” (what you can
deliver above and beyond the market).
Banks are abandoning their old budgeting
process and are using the baseline CCAR
projection by adapting it to their budget for
the next year. However, one shouldn’t slavishly
adopt the model output; in fact, there may
be very good reasons to deviate, deliberately,
from a model’s best estimate of, say, revenue
growth, given expected economic and
market conditions. Senior management may
wish to set some stretch goals to encourage
prudent growth relative to what would happen
organically. This is not wishful thinking. As
a senior client told us recently, CCAR-based
budgeting “simply works better.”
DECONSTRUCTING ALPHA
An actual client experience brings home this
idea. As part of vetting CCAR results, one
business unit was proposing, for its budget,
5 percent growth over the coming year. But
the CCAR model’s baseline projection was just
3 percent. This raised some questions among
the executives, including the chief executive
officer: How was the business proposing to
generate the additional 2 percent, the “alpha”,
that the economy was not projected to deliver
for the company? Would it be through more
aggressive pricing, stronger sales (achieved
perhaps by lowering risk limits), or more
effective customer retention?
This question triggered a rather spirited
debate. After the meeting, members of the
team told us that such a robust and disciplined
discussion on growth targets would not have
been possible even a year earlier.
Come year-end performance evaluation,
and compensation discussions, a natural
question to ask is: How did you do relative
to budget, relative to those stretch goals?
One of the hardest problems in performance
evaluation is in separating skill from luck. In our
client example, if the business unit delivered
7 percent instead of the promised 5 percent
growth, was that because of creativity,
ingenuity, and grit – or did the economy just
turn out better than what had been expected
at the time the budget was generated?
The CCAR machine can help to answer
this question.
STRATEGIC PLANNING
If CCAR can help with budgeting and
performance, it’s not a big leap to consider
how it can improve strategic planning. In
which areas should the bank seek growth,
where should it shrink, and where might
inorganic growth be called for? Moreover,
how do these ideas play out in the firm’s
financials – earnings and balance sheet – and
what are the economic conditions that would
need to transpire for the strategic plan to work
well, just squeak by, or actually fail?
REVAMPING BUSINESS MODELS
43
If CCAR can help with budgeting and performance, it’s not a
big leap to consider how it can improve strategic planning
In fact, the real benefit of stress testing
and CCAR – although still untapped
and unrecognized – arguably may lie
in its potential for facilitating a more
rigorous, robust, and credible strategic
planning process.
The regulator has a narrow interest: Is there
sufficient capital and capital generation
capacity to support this strategic plan,
even if the economy were to go south? Senior
management, the board, and shareholders,
on the other hand, have much broader
interests: They care about the upside along
with the downside. The CCAR machine can
help with both: It can warn about the downside
risks and inform about the upside potential.
Thanks to CCAR, that strategic planning
machinery has now been built! And it can
be put to good use answering a number of
strategic questions. As an example, consider
the following: where should the bank invest its
next marginal dollar of assets? As constraints
on a bank – imposed both internally by, for
example, the firm’s risk appetite, and by
supervisors – increase in both number and
complexity, this question becomes more
difficult to answer.
Take the stylized example in Exhibit 1: A
bank has a number of constraints intended
to measure its financial strength that it must
respect – leverage, a risk-based Tier 1 capital
ratio (capital over risk-weighted as opposed
to unweighted assets like the leverage ratio),
liquidity – but it has some headroom with
which to maneuver. The bank may consider
several strategies to take advantage of
this headroom, but one strategy may push
against one constraint, say leverage, while
another may get the bank close to a different
constraint, say liquidity. The first question to
answer is whether the bank can stay within
ExHIBIT 1: STRESS TESTING STRATEGIES
BANK’S COMPREHENSIVE CAPITAL ASSESSMENT AND REVIEWS HELP SET STRATEGIES BY STRESS TESTING ALTERNATIVES
CURRENT POSITION STRATEGY ALTERNATIVES
QUESTION 1
In bounds?
QUESTION 2: RISK/RETURN FEATURES
ProfitsReturn on
capitalReturn on
equity
Strategy I
Strategy II
Strategy III
NA – strategy violates Leverage Ratio
Leverage
Tier 1 ratioLiquiditycoverageratio
Constraint E
Binding constraint;strategy must remainwithin this line
“Headroom” between current position and binding constraint
Constraint D
Source: Oliver Wyman analysis
RISK JOURNAL | VOLUME 5
44
its constraints, by passing CCAR, for example,
while remaining within its own risk tolerances,
across each of the possible strategies.
Here, the ability of the CCAR/strategic
planning machine to capture downside risks is
key. Strategy II fails this test (via a leverage ratio
breach) and must be discarded. For strategies
that pass this first test, the next question is
one of classic risk/return optimization. Here,
the ability of the CCAR machine to capture
baseline expectations and upside potential is
highlighted. Among the remaining strategies,
the CCAR machine can be used to pick the
strategy offering the best return: Strategy I.
This is just one of the lemonade recipes we
have been exploring with our clients. There are
many more, equally promising, recipes. They
are moving from the test kitchen to the main
dining room, and the taste is getting sweeter
by the day.
Michael Duane and Til Schuermann are both New York-based partners in Oliver Wyman’s Financial Services practice. Schuermann is a former senior vice president at the Federal Reserve Bank of New York.
REVAMPING BUSINESS MODELS
45
RETHINKING TACTICS
Revamping Risk Cultures
Three Lines of Defense in Financial Services
Fines and Financial Misdemeanors
Liquidity Risk
RISK JOURNAL | VOLUME 5
REVAMPING RISK CULTURES IT’S TIME FOR COMPANIES TO FOCUS MORE ON BEHAVIORAL BLIND SPOTS
Bill Heath • Kevan Jones • Sir Hector Sants • Richard Smith-Bingham
One employee treats a client poorly.
Another allows key equipment to rust.
A third witnesses poor conduct by
colleagues yet does nothing. A leader makes
a snap decision without thought.
Taken separately, each one of these actions
may seem trivial. But together, they add up
to one of the main reasons why the many
initiatives undertaken by companies over the
past five years to strengthen their risk cultures
continue to fall short: Too few firms give
behavior the attention it deserves.
Companies have invested significant time
and effort into implementing structural
changes designed to prevent a repeat of past
egregious risk management lapses that have
cost them hundreds of billions of dollars in
fines and litigation costs. (See “Fines and
Financial Misdemeanors,” on page 58.)
Many have strengthened their enterprise
risk management frameworks by carefully
defining and communicating their risk
appetite, clarifying accountabilities and
responsibilities for risk taking and risk
management, and sharpening operational
rules and procedures. They have reinforced
their so-called three lines of defense,
enhanced their reporting capabilities, and
taken steps to better embed risk management
in performance compensation. (See “Three
Lines of Defense in Financial Services,” on
page 54.)
In many cases, these structural remedies
create a false sense of security, in part because
most are not accompanied by an interest
in understanding why people act the way
they do. The behavioral dimension of a risk
culture is often more difficult to detect and
address than blatant misconduct. A trickle of
low-level transgressions and oversights can
erode a firm’s value over time – and can also
help to serve as an early warning for more
serious and significant incidents. That’s why,
for example, firms in high-hazard industries
track first-aid cases at their facilities: They
know that the manifestation of low-level
injuries is symptomatic of actions that could
result in a fatality. At the same time, they need
to be mindful that focusing on slips, trips,
and falls does not blind them to different
types of cultural challenges that may lead to
catastrophic incidents.
RETHINKING TACTICS
49
ExHIBIT 1: RISK CULTURE AND PERSONNEL BEHAVIOR
COMPANIES CAN APPLY DIFFERENT APPROACHES TO STRENGTHENING RISK CULTURE. THE DIAGRAM BELOW INDICATES WHAT PERSONNEL BEHAVIOR MIGHT LOOK LIKE DEPENDING ON WHICH TYPES OF INITIATIVE ARE PRIORITIZED.
DISMISSIVE CONTROLLED ANTICIPATORY
APATHETIC COMPLIANT COMMITTED
IGNORANT INQUIRING INHIBITED
Adequate
Limited
Robust
Detached Involved Proactive
STRUCTURAL – GOVERNANCE
BEHAVIORAL – ENGAGEMENT
“There are so many rules, it is hard to get anything done in the time available unless you cut corners”
“I follow the rules and procedures that are laid down, even though they can be a bit of a strait-jacket at times”
“I have a strong risk platform for my work and am stimulated to think about enhancements”
“There is enough leeway in the risk guidance that I can do my own thing when it suits me”
“I follow what require-ments exist, largely to avoid punishment for breaking them”
“I seek to make good risk decisions and look out for others but gaps in our framework give me concern”
“The company is just interested in getting the job done with minimal bureaucracy – which suits me fine”
“Guidance is lacking, so I make judgments about what is best for me and what makes sense”
“I make every effort to anticipate risks, but would appreciate more support from the firm and my peers”
Source: Marsh & McLennan Companies
The structural aspect of building a strong risk
culture is, for the most part, defensive in nature,
seeking to place constraints on poor practices,
decisions, and activities. The behavioral
dimension, on the other hand, primarily
focuses on influencing and promoting good
practices, decisions, and deeds. It relates more
to maintaining, or in some cases regaining,
a “social license” through the disposition of
individual personnel; the respect they have for
colleagues, customers, and suppliers; and their
level of commitment to the risk agenda and
the values of the firm. (See Exhibit 1.)
OVERCOMING BIASES
Sustained behavioral change requires
influencing people both rationally and
emotionally, formally and informally,
consciously and subconsciously. Personnel
RISK JOURNAL | VOLUME 5
50
must be guided and supported to act in an
appropriate manner, rather than being
tasked to do so. They must feel like they are
choosing to behave in the right way for the
right reasons.
Neuroscience has shown that changing or
developing a behavior is different from learning
or doing a task. The part of the brain where new
behaviors are learned and embedded is rarely
engaged when someone is given an instruction
or offered short-term incentives.
To address the behavioral neural networks
where beliefs and habits reside and to “rewire”
them, individuals and teams must be taken
on a journey led by their company’s board of
directors and top management. Studies show
that employees take cues from their leaders
and immediate supervisors to determine
whether a commitment to a shift in conduct is
real or merely rhetoric. If the board and senior
executives hope to motivate their staff and
employees to undertake the journey, they first
must make strengthening the risk culture a
personal goal of their own. They must embody
the desired risk culture through their own
actions. Their passion for change must be both
visible and felt, with meaningful consequences
for both right and wrong behaviors.
Leaders must also be aware that changing
actions and the associated culture is a
long-term endeavor. Boards and management
teams must not only own the firm’s risk culture,
but also must monitor its impact on a regular
basis. Progress can easily be undermined. A set
of posters announcing a new corporate culture
does nothing to persuade people the effort is
real. And six-months’ work can be destroyed
with a single poorly phrased communication
from leadership.
Few firms give behavior the attention it deserves
TAPPING INTO PERSONAL MOTIVATION
Leaders that are successful in this endeavor are
able to tap into two powerful factors: personal
motivation and iterative learning. In regard to
the first one, management can ensure that risk
issues resonate deeply with staff by appealing
to their commitment to the firm’s success, the
impact on customers, the implications for their
career, and the power of their own agency.
At a high level, employees must understand
how their individual activities link to the
strategy of the firm and its long-term
success – and ultimately to their own
individual rewards. Then they must be given
objectives consistent with the broader
purpose and set of desired actions, so that
assessment of their performance relative to
expectations, either positive or negative, can
be attributed to outcomes.
This is often easier said than done, as it
can be difficult to predict the impact of
initiatives. For instance, after a fatality on
the United Kingdom’s North Sea, it became
apparent that conducting “temporary”
maintenance on one oil rig had become
permanent. When asked why, staff said they
thought their leaders wanted them to reduce
costs, irrespective of risk, despite countless
presentations from leaders highlighting how
safety should come first. In another instance,
an energy supplier inadvertently demoralized its
RETHINKING TACTICS
51
employees and did little to raise its standards
when it benchmarked its safety record against
its competitors. But when the company
introduced an internal competition between
its own facilities, employees were motivated
to improve risk practices and become
“safety champions.”
Understanding what drives behaviors is more
complex than one would think. Psychologists
have proven that there are many cognitive
biases hard-wired into the human mind. The
most commonly cited is “normalization.”
This term refers either to situations when
unacceptable risk-taking becomes accepted
as the norm due to the lack of incidents or to
a readiness to accept accidents as a matter of
course and an inherent cost of doing business.
Organizations with stronger risk cultures
develop practices that enable employees to
become aware of and overcome these biases.
For instance, it is now common for engineers
in high-hazard industries to brainstorm all
potential risks and outcomes every three to
five years to test that current processes are still
adequate. Other industries, such as healthcare,
have started to collect performance data to
identify where decisions are being repeatedly
made as a result of certain cognitive biases.
LINKING PROMOTION AND PAY TO BEHAVIOR
One way to underscore the link between a
strong risk culture and the firm’s long-term
success and individual compensation is for
management teams and staff to integrate
cultural and value evaluations into year-end
performance appraisals. These components
should consistently and significantly affect
remuneration and advancement – even at
a senior level. For example, some banks
have begun to adjust their executive team’s
compensation by 50 percent based on the
bank’s financial performance and 50 percent
based on assessments of tangible improvements
to its culture, as defined in terms of desired
conduct and values. Some energy firms
recognize and reward employees for adopting
a sound risk-management practice pioneered
by someone in another division.
RISK JOURNAL | VOLUME 5
52
Firms must also reward behaviors that
are positive and are beyond the minimum
threshold set by their internal code of conduct,
as part of staff development and promotion
decisions. Companies should go out of their
way to celebrate individuals who escalate
potential issues, support colleagues who clearly
put the company ahead of themselves, perform
outstanding client or community work, or
demonstrate internal leadership on diversity
or inclusion initiatives. At the same time,
recruitment processes should be recalibrated
to support these values and “cultural fit.”
By celebrating those who exhibit the desired
values, while also having effective sanctions
for bad behaviors, leaders can encourage
employees to escalate difficult issues, which
is essential for companies seeking to embed
desired behaviors on a sustained basis. For
example, some energy firms publicly honor
and reward employees who stand up for
safety against the odds. Without such public
acknowledgement, employees may be afraid
of the consequences and prefer to engage in
“willful blindness.” But care needs to be taken
that the financial incentive is not so big that it
tempts personnel to “rig” feedback.
ITERATIVE LEARNING
It is also important for leaders to encourage
individuals to experiment with new behaviors
and repeat them until they become second
nature. Companies need to be creative about
engagement opportunities – developing
learning loops to nurture new actions,
blending formal training with informal
nudges, and paying attention to such details
as discussion formats, vocabulary choices,
and even office design.
Initiatives should not only embrace
experimentation, but also be regularly
repeated and new behaviors periodically
discussed over a number of months. For
example, one bank that set out to tackle
inconsistent training and development
messages systematically inserted values and
examples of appropriate conduct into all of its
training and development processes.
At the end of the day, the art of molding
desired actions requires making subconscious
decisions conscious and then engraining new
practices into subconscious behaviors again.
Initiatives that simply focus on the conscious
brain and overt, rational decision making
will fall short of their goals, as will efforts that
assume behavioral adjustments follow from a
single intervention. Instead, a firm’s risk culture
must be continually reviewed and improved,
as it is constantly evolving and influenced by
leaders and events.
SEEING WHAT’S COMING
By allowing behavioral blind spots to flourish,
companies permit their risks to remain
invisible. No one wants to hurtle straight
towards a full-blown crisis because they didn’t
see it coming. Making behavior an integral
part of risk culture should be at the top of
every company’s “fix-it” list.
Bill Heath is a London-based partner in Oliver Wyman’s Energy practice. Kevan Jones is a London-based partner and head of Oliver Wyman’s People Effectiveness practice. Sir Hector Sants is a London-based partner and vice chairman in Oliver Wyman’s Public Policy practice. Richard Smith-Bingham is a London-based director in Marsh & McLennan Companies’ Global Risk Center. Oliver Wyman is a division of Marsh & McLennan Companies.
RETHINKING TACTICS
53
THREE LINES OF DEFENSE IN FINANCIAL SERVICES FIVE SIGNS THAT YOUR FIRM IS LIVING A LIE – AND WHAT TO DO ABOUT THEM
Mark Abrahamson • Michelle Daisley • Sean McGuire • George Netherton
Ask any bank or insurance company
today about how they organize
themselves to manage the risks they
face and you will undoubtedly hear about
their “three lines of defense”: risk taking, risk
oversight, and risk assurance. Broadly, the first
line is made up of the risk takers – who must
own and track the risks they generate. The
second line is an independent body within the
organization that sets risk-taking limits and
ensures that all risks are being appropriately
managed. The third line audits and verifies the
efforts of the other two to ensure that nothing
falls through the cracks. (See Exhibit 1.)
This conceptual framework has governed the
industry’s approach to risk management for
some time, but few financial services firms
are really “walking the walk” when it comes
to putting this into practice. In the summer
of 2013, the United Kingdom’s Parliamentary
Committee on Banking Standards lambasted
British financial services firms for paying lip
service to the framework: “Responsibilities
have been blurred, accountability diluted, and
officers in risk, compliance, and internal audit
have lacked the status to challenge front-line
staff effectively.” More recently, the Basel
Committee on Banking Supervision revised its
principles for banks in part to “strengthen the
guidance on risk governance, including the risk
management roles played by business units,
risk management teams, and internal audit and
control functions (the three lines of defense), as
well as underline the importance of a sound risk
culture to drive risk management within a bank.”
The fundamental foundations of the model
are sound: They are designed to offset
asymmetric information, incentives, and
natural optimism. And certainly, empowering
professional pessimists to give voice to the
“glass half empty” view of the world is sensible
governance. But use of the model to deliver
effective risk management requires a level of
specificity and thoroughness that, to date,
has largely been lacking from the industry.
As a concept, the three lines of defense
may be comforting. But without concrete
follow-through by senior managers and
boards, they can only provide a false – and
perilous – sense of security.
RETHINKING TACTICS
55
LIVING A LIEThere are five common signs that a financial
institution might be purportedly “adopting” the
three lines of defense, yet might not be living the
three lines of defense in practice, in the sense
of consistent and rigorous implementation – in
other words, living a lie. This exposes the
business to bad outcomes: off-strategy losses,
groupthink, overconfidence, onerous control
costs, or key judgments left unchallenged.
These problems often come about because the
business, risk, and audit functions have failed
to jointly agree on risk ownership and activities
in a holistic and comprehensive way, and senior
management has failed to retain a sufficient
level of granularity to be confident the model is
genuinely being implemented.
The first of these signs is a “theater of the
abstract.” Institutions adopt the model, but fail
to build out a list of risk activities and translate
them into appropriate policies, process
changes, and job descriptions. Worrying
words might be: “It’s more of a high-level
construct here” and “our processes are about
people making the right decision – not what
hat they wear.”
ExHIBIT 1: THE “THREE LINES OF DEFENSE” FOR FINANCIAL SERVICES
THE THREE LINES OF DEFENSE FRAMEWORK HAS LONG GOVERNED THE FINANCIAL SERVICES INDUSTRY BUT HAS RARELY DELIVERED EFFECTIVE RISK MANAGEMENT
1. ACCOUNTABILITYPeople who benefit from taking risks should be accountable for those risks
2. INDEPENDENT CHALLENGEGiven asymmetric incentives, short-termism, and the natural optimism of risk takers, an independent control function is required to ensure risks are identified, controlled, and managed within appropriate boundaries
3. ASSURANCE AND REVIEWIndependent assurance that the risk taker and risk controller interaction is working
Source: Oliver Wyman analysis
Another sign of a fundamental problem is not
knowing whose line it is – that is, not clearly
separating out roles to avoid underlapping
and overlapping. “We cover all three lines of
defense” is not what you want to hear from any
team in the organization. Allocating multiple
lines to one person or group, or creating “safety
blanket” teams to satisfy regulators, completely
undermines the model.
A third indicator is that only the easy
questions about risk are getting answered.
“The model doesn’t fit the reality of some
parts of the business” is a clear warning sign.
The firm may be failing to assign explicit
responsibility for sensitive topics or grey
areas, or to account for new and emerging
risks, such as cybersecurity.
Just like contempt, familiarity can also breed
complacency: “It’s been like this for years,
everyone knows their role.” A strong and
up-to-date risk management system requires
regular updating to counter drift and ensure
that all risks are accounted for.
Or worse, there can be a glaring gap between
what executive teams assume the lines of
RISK JOURNAL | VOLUME 5
56
defense teams are focusing on and what is
actually happening, in part due to broad
mandates. Unless key tasks are explicitly
owned by a team, second line resources may
remain overwhelmingly devoted to regulatory
compliance and risk modeling. Words a senior
manager never wants to hear, but often does,
are: “We’re not sure if that is a first or second
line responsibility.”
BUILDING A DEFENSE THAT WORKS
If a financial-services firm is exhibiting one
or more of these signs, it may be time for an
intervention at the C-suite or board level. Poor
risk management is expensive, inefficient, and
dangerous: Redundancy of roles and processes
cost money and add to red tape, without
delivering better outcomes. Decision making
slows when mandates are unclear and people
lose confidence in the model. Finally, the board
and regulators may unwittingly believe that
the firm has comprehensive, independent,
and expert independent challenge when it
doesn’t – a state of affairs that will quickly
come to light in the event of a business or
market failure.
Of course, the three lines of defense are
intended as a framework, one that must be
tailored for each firm’s unique circumstances
and business model. But there are some
commonalities to its effective use. Critically, the
second line – independent oversight – must
ensure both top-down and bottom-up risk
capture: It owns the risk identification
process – including external and emerging
risks – and reports on risks to the board
and senior management. But it also should
be charged with ensuring that senior
management and board discussions on risk at
the strategic level are occurring regularly, with
outcomes incorporated into risk parameters, to
create an effective feedback loop. Equally, it’s
important that the third line, assurance, goes
beyond simply auditing the other two lines on
a stand-alone basis, and takes responsibility for
ensuring the relationship between the two is
neither too close nor too distant.
Beyond this, clear documentation and
communication, fully embedding the model,
regular testing and refreshment, and evidence
of independent debate and challenge are
necessary to make risk management a living,
breathing part of the organization.
With sufficient clarity of thinking, management
drive, and determined execution, the three
lines of defense can be transformed from
“words to live by” to a functional bulwark that
can protect the business in good times and in
bad. But to be truly effective, the model needs
to evolve as the business evolves.
As a concept, the three lines may be comforting. But without
concrete follow-through, it can only provide a false sense
of security
Mark Abrahamson is a London-based principal, Michelle Daisley is London-based partner, Sean McGuire is a London-based partner, and George Netherton is a London-based principal in Oliver Wyman’s Financial Services practice.
RETHINKING TACTICS
57
FINES AND FINANCIAL MISDEMEANORS FINANCIAL CRIME IS THE NEW MATERIAL RISK FOR BANKS
Dominik Kaefer
Over the past year, regulators in the
United States, United Kingdom, and
the European Union have hit banks
with more than $9 billion in fines for having
rigged the London Interbank Offered Rate,
better known as Libor. Libor – a critically
important interest rate, upon which trillions
of dollars in financial contracts rest – is used
by banks as the benchmark for setting rates
on consumer and corporate loans. In April,
Deutsche Bank alone was fined $2.1 billion
by US financial watchdogs and $348 million
by the Financial Conduct Authority in the UK
to settle charges that it allegedly participated
in manipulating Libor, while the other banks
involved in the scheme each paid more than a
billion dollars in fines.
But the Libor case is only one in what seems
to be a spate of financial misdemeanors.
In a separate action, BNP Paribas agreed
in June 2014 to pay nearly $9 billion and
plead guilty for having violated US sanctions
rules against Cuba, Iran, and Sudan. In
November 2013, JPMorgan Chase paid
$13 billion to settle various charges concerning
mortgage securities that it had sold prior to
the financial crisis, the largest fine ever paid
by a US corporation. Before that, HSBC was
fined $1.9 billion in December 2012 following
a US Senate investigation into the role it played
in laundering money of drug dealers and
“rogue nations.”
Multibillion-dollar fines for alleged respectively
committed financial crimes have become a new
material financial risk for financial firms. In just
five years, such fines have grown from being so
miniscule in relation to banking industry profits
that they were treated effectively as being nil,
to totalling almost $58 billion in 2014. The
average fine has increased seventy-fold in the
past six years, rocketing from $22 million in
2008 to nearly $1.6 billion in 2014.
But the true cost of an adverse finding from
legal or banking authorities goes far beyond
the specific fine imposed. The real harm lies in
the almost incalculable damage that has been
done to the bank’s reputation. Banks face
the risk that customers and counterparties
will lose confidence in the bank’s sustainable
performance, pushing up the cost of capital.
And investors fear that the fines are actually
harbingers of bad news to come and that the
bank is likely to suffer future unexpected losses,
thus adding to negative market reactions.
Many commentators attribute these larger
fines to deteriorating ethics among bankers.
But the real change, in fact, has not come from
bankers. Instead, the true transformation can
be traced to those whose role it is to regulate
the financial services industry. Until recently,
bankers were subject to little scrutiny. In fact,
it may be that for all we know, bankers in the
1970s were just as inclined to misrepresent
risks and conspire to manipulate market
prices. Certainly, offshore banking and account
secrecy, which have recently been condemned
for facilitating tax evasion and money
laundering, are nothing new.
By contrast, regulators have clearly responded
to the widespread criticism and perception
that the financial crisis was a failure of banking
supervision by becoming much tougher on
the banks they supervise. They are demanding
unprecedented levels of disclosure and are
applying massive fines when wrongdoing is
discovered. The notion of wrongdoing has
even been extended to include poor risk
management. When JPMorgan Chase lost
$6 billion in the London derivatives market,
the bank’s woes were compounded by fines
imposed by US and UK authorities of about
$1 billion for poor risk oversight.
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59
MANAGING THE SHIFT FROM VICTIM TO ALLEGED PERPETRATOR
In this new environment of intense scrutiny and
massive fines, banks must take a more rigorous
approach to managing the risk of financial
crime – not the risk of being a victim of crime but
the risk of being a perpetrator or accomplice.
To date, managing financial crime risk has often
been treated as a simple matter of mechanically
complying with “know-your-customer” and
anti-money laundering regulations. The
inadequacy of this approach is now clear. Apart
from the HSBC scandal, the big fines of recent
years have concerned conduct outside the
scope of these regulations.
Besides money laundering, senior bankers
must make sure their institutions are not
involved in tax evasion, bribery, corruption,
ExHIBIT 1: THE FINANCIAL CRIME WAVE
BANKS’ FINANCIAL FINES ARE SKYROCKETING, INCREASING CUMULATIVELY BY NEARLY 3,000 PERCENT OVER THE PAST FIVE YEARS
2009 20102008 2011 2012 2013 2014 Cumulative2009-2014
.16 2.0 3.3 3.7
32.1
52.1
57.7 150.9+2,851%
$ BILLIONS
Source: FT Research, Oliver Wyman analysis
or terrorism financing. They must also be sure
that they abide by sanctions and embargoes
and not participate in market abuse. Moreover,
banks must not only be law-abiding, they must
also be virtuous, given the extension under
the UK’s Financial Conduct Authority of the
regulator’s power to evaluate a bank’s “culture”
and impose penalties on it.
Clearly, part of the answer towards putting
an end to the banks’ misdemeanors lies in
fostering a cultural change. Banks must use
recruitment, promotion, training, and financial
incentives to encourage a high standard of
business ethics. Not only will such measures
reduce the chances of wrongdoing, but they
are also likely to reduce the severity of penalties
when such offenses occur. The standard
management response to a scandal – that
the malfeasance was a “rogue event” and not
symptomatic of a corrupt culture – will be more
believable if banks take these measures.
RISK JOURNAL | VOLUME 5
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EFFECTIVE CULTURAL CHANGE
Such cultural change programs are already
underway at many banks. To gain greater
traction, however, those efforts must be
backed by stronger internal scrutiny of staff
and client conduct. This self-imposed scrutiny
does more than just discipline staff. It helps
to ensure that senior managers are ahead of
the media and their regulators and that they
are initiating action. If a senior manager is
surprised by what external investigations
uncover, that can only confirm suspicions
that he has lost control.
The first step to achieving effective cultural
change is figuring out where to look for
problems. For this purpose, banking
supervisors often recruit ex-bankers to help
them understand how bankers behave.
In a variation on this “poacher turned
gamekeeper” tactic, banks are now recruiting
ex-supervisors to help locate the behaviors
that concern the authorities.
Banks must then be able to detect misconduct
by their staff or clients. To this end, banks are
moving beyond traditional risk management
and into the kind of techniques more
commonly associated with spy agencies
such as the CIA and MI5. They are using
advanced analysis of transaction patterns,
communications, and social networks to
identify potentially criminal or unethical
behavior. And they are being more vigilant
about analyzing geopolitical risks and the
individuals with whom the bank is associated.
If the bank’s chief executive officer is going to
have lunch with a political or business bigwig,
then the bank needs to know who that person
really is and what risks he may carry with him.
Dominik Kaefer is a Frankfurt-based principal in Oliver Wyman’s Financial Services practice.
70xThe number of times that
the average fine for banks soared from 2008 to 2014
Banks are also increasing their financial
crime risk-fighting resources. In 2009,
they spent roughly $4 billion on relevant
externally-supplied software and services.
In 2014, that figure jumped 60 percent, to
$6.5 billion. While that may be a significant
increase, it is not nearly as great as the
3,000 percent increase in the fines for
financial crime incurred over the same
period. (See Exhibit 1.)
VIRTUE’S REWARD
Virtue is its own reward, according to Cicero.
That may well be true. But even if it isn’t,
when the public, the press, politicians, and
supervisors assume that banks are up to
no good and are keen to punish them, virtue
has another important bonus: It enables
banks to remain in business. If the banks hope
to be profitable, they had better learn to also
be good.
RETHINKING TACTICS
61
LIQUIDITY RISK UNCOVERING THE HIDDEN CAUSE OF CORPORATE SHOCKS
Alexander Franke • Ernst Frankl • Adam Perkins
International conflicts, an uncertain global
economy, and volatile stock prices are
prompting management teams to examine
whether they would fare better in a liquidity
crunch today than they did when the financial
crisis struck seven years ago. Unfortunately,
the answer to that question is unclear. On
the positive side, banks and non-financial
companies have both been shoring up capital
reserves, partly in response to new regulations.
But unlike banks, which have been forced
by regulators to make strengthening their
liquidity risk management capabilities a top
priority, many businesses have not improved
their ability to analyze and mitigate funding
shortfalls. A study by the United Kingdom’s
Financial Conduct Authority released in
September found that most commodity traders
do “not include stress testing and scenario
analysis in their assessments of liquidity risk.”
This could result “in large financial pressures
and liquidity risks in the event of stressed market
conditions,” according to the report. Our
research shows that liquidity-risk management
may be an even lower priority for many
non-financial services companies. In our
view: too low.
In a recent Oliver Wyman survey, we asked
commodity-driven industrial conglomerates
and asset-backed traders about four critical
liquidity-risk-management best practices:
comprehensive assessments of sources and
uses of liquidity; robust risk and reserve
calculations; thorough stress testing; and
integrated risk and finance evaluations. We
found that only some players are following best
practices in terms of liquidity-risk assessment
and provision planning, such as taking a wide
range of risk factors into consideration and
conducting extensive stress testing. But even
then, these practices are only being applied in
isolated cases. Not one company
is consistently following best practices
for liquidity-risk management across all
four dimensions.
Instead, most respondents report that they
have only basic liquidity-risk management
practices in place. For example, many
companies just examine how market price
movements will force them to seek more
funding. Or they fail to seek the views of both
their treasury and risk divisions when stress
testing their potential access to funding.
(See Exhibit 1.)
There is more work to be done: One of the
main reasons that liquidity risk remains a low
priority for many organizations is that they
do not have a robust enough understanding
of how much their organization is at risk of a
funding shortfall – or they underestimate the
steps required to close the gap. The financial
crisis has taught us that liquidity risks are the
greatest risks of all in terms of bankrupting
a company. But they are difficult to foresee
without careful forethought and preparation.
That’s because they usually occur when risks
correlate, overlap, or combine to result in
a full-blown crisis. To meet this challenge,
liquidity-risk management must be a
comprehensive attempt to predict the
impact of a perfect storm.
Businesses do not have an accurate understanding of
the extent to which their organizations remain at risk of
funding shortfalls
RETHINKING TACTICS
63
FIVE COMMON MISTAKESTo take advantage of all that we have learned
from the financial crisis and avoid repeating
history, companies will need to avoid the
five most common mistakes in liquidity
risk management:
1. Choosing a narrow risk perimeter. As we
learned from the financial crisis, companies
can suffer from a shortfall of financial
resources when a risk event suddenly
creates an unexpected need for funding
or when external sources for funding
suddenly become unavailable, or both.
Generally, companies must be prepared for
three types of risk events – market, credit,
and operational – which could happen
simultaneously. Examining all three types
of risks also can help organizations to avoid
double counting available reserves.
Unfortunately, most businesses tend to
focus solely on market risks that could cause
their cost of funding to spike or trigger
margin calls from derivative contracts. Few
companies regularly evaluate the potential
impact of credit risks produced by delays
in payments or cancelled deliveries of
products that have already been paid for.
Or they fail to examine the potential impact
of operational interruptions that could
require funds or harm a company’s ability to
generate cash.
2. Overlooking tail events. The second most
common mistake is that companies rarely
analyze what could happen if a risk event
occurs that is outside of their regularly
considered range of possibilities. Most
businesses examine if they have sufficient
financial strength to weather an event
that has somewhere between a 1 percent
to 5 percent chance of occurring. But few
conduct stress tests and scenario analyses
to understand the potential impact of
ExHIBIT 1: THE FIVE COMMON MISTAKES IN LIQUIDITY RISK MANAGEMENT
PRACTICES THAT SHOULD BE AVOIDED TO PREVENT A FUNDING SHORTFALL
5. Operating in silos
4. Misjudging funding risks
3. Underestimating the importance of time
2. Overlooking tail events
1. Choosing a narrow risk perimeter
I II III IV I II III IV
Source: Oliver Wyman analysis
RISK JOURNAL | VOLUME 5
64
so-called “tail” events that are outside
a company’s regularly considered
risk purview.
Or they analyze tail events in a mechanical
way. They don’t bring into consideration
the views of external experts or even tap all
of the business intelligence that may exist
within their own organization’s four walls.
3. Underestimating the importance of time.
Another frequent error is that companies
fail to consider how their exposures change
over time. Most calculate their potential
liquidity shortage over one quarter and then
apply those requirements over a year’s time.
Or they ignore this step entirely. As a result,
they fail to take into account how much their
liquidity requirements could rise when their
company pays dividends, for example. Or
conversely, businesses may be unaware that
they will need fewer reserves at other points
in the year.
For example, the European Union voted in
January 2013 against a plan to support the
European Trading Scheme (ETS) for carbon
and auction off yet more carbon credits. If
the announcement had come several weeks
later, it could have resulted in a full-blown
liquidity crisis for many traders. As it was,
after the announcement, carbon prices
went into free-fall, dropping by 40 percent,
and triggering hundreds of millions of
dollars in margin calls on hedges. Traders
were only able to meet their commitments
by borrowing in the short term from their
dividend reserves. Had the dividends
already been paid and those reserves been
depleted, many traders would not have
been able to weather the shift as easily.
4. Misjudging funding risks. Trying to
understand the risks associated with the
uses of liquidity is a common process
for risk managers. But issues such as the
availability of funding and the associated
risks come less easily to them. As a result, few
companies regularly assess the potential
funding and liquidity problems that could
result if lenders shut down credit facilities
or if corporate treasuries cut funding
for subsidiaries.
But paying greater attention to potential
funding shortfalls caused by unexpected
moves by counterparties is becoming
critical. Banks and investors are increasingly
worried about high debt levels and weak
earnings in the current uncertain economic
environment. In fact, some prominent
independent traders have already begun to
report that counterparties are starting to trim
their credit lines.
5. Operating in silos. Intuitively, it may
seem obvious that liquidity risk is too
interconnected, complex, and potentially
fatal to be analyzed by a single division. Yet
seven years after the financial crisis, many
companies still assign the responsibility of
monitoring liquidity risk either to the risk
division, since it is closely tied to market
and credit risk, or to their treasury, since
liquidity risk relates to working-capital
management and funding. Firms often
assign tasks such as calculating liquidity
risks, setting liquidity reserve requirements,
and determining funding requirements and
provisions to a single division or spread out
the work across segregated teams in silos
that don’t communicate with each other.
This failure to collaborate causes significant
gaps in companies’ liquidity-risk analyses.
Perspectives from a company’s treasury
department are critical to determining cash
allocation and funding. But these insights
fall short of identifying a firm’s actual
liquidity risk without the risk division’s view
on potential fluctuations in cash inflows
and outflows and the financial planning
division’s assessment of the firm’s future
minimum liquidity requirements.
RETHINKING TACTICS
65
A MULTIDISCIPLINARY APPROACH
So what can be done? Ultimately, companies’
chief financial officers and chief risk officers need
to work together to ensure that their risk, treasury,
and financial planning divisions are interacting
with each other to assess the company’s liquidity
requirements, potentially as part of their annual
planning and budgeting process. By taking
advantage of the expertise that exists across the
company, they can be sure they are considering
all potential risks to funding.
Leaders in this area include in their
multidisciplinary analyses improbable and
unforeseen events. They compile an exhaustive
risk register across divisions, which include
assessments of different types of liquidity risks,
ExHIBIT 2: FORECASTING FUNDING SHORTFALLS
COMPANIES MUST ADOPT A MULTIDISCIPLINARY APPROACH TO IDENTIFY THE FULL ExTENT OF THEIR FUNDING SHORTFALL
Marketrisk events
Creditrisk events
Operationalrisk events
Base case(1:20 year)
1 in 100 year case
1 in 1,000year case
Managementadjustment
Final liquidityreserve
requirement
Base case Stressed case
A. BASE CASEUncorrelated basescenarios
B. STRESS CASESSimulated stress scenarios
C. FINALLIQUIDITY RESERVEREQUIREMENTManagement discussion
D. AVAILABLEFUNDINGSimulated stress scenarios
fundingshortfall
Source: Oliver Wyman Analysis
and then assess their likelihood, impact,
and potential interplay with other risks.
(See Exhibit 2). Then they evaluate what the
company’s liquidity requirement will be when
major liquidity risk events occur that could
happen once in 20 years, once in 100 years,
or once in 1,000 years. These individual
reserves are then aggregated to give the total
base and stressed liquidity requirement.
The company’s top management team can
then adjust the company’s final reserve
requirement based on the company’s risk
appetite and its willingness to pay for cash
reserves or unused credit lines. By matching
the requirements for “business as usual”
against a stressed funding scenario, the
management team can gain a more accurate
picture of how large a funding shortfall should
be addressed.
RISK JOURNAL | VOLUME 5
66
ADDRESSING FUNDING SHORTFALLS
Once companies grasp the full extent of
their potential funding gap, they can create
a strategy for changing the way they address
potential shortfalls in financial resources and
incorporate these shifts into their overall
strategy for managing risks. But developing
such an integrated approach can only happen
if companies attempt to bring the limits
associated with their reserve calculations in line
with their changing appetite for risk and overall
funding plans.
Companies must examine a wide range
of scenarios to determine both the cost of
different sources of funding and the likelihood
Alexander Franke is a Zurich-based partner, Ernst Frankl is a Frankfurt-based partner, and Adam Perkins is a London-based engagement manager in Oliver Wyman’s Energy practice.
of their access to financial resources. For
example, companies should be prepared for
separate divisions to draw down on reserves
at the same time and examine how internal
transfer prices and competition for funding
could affect funding availability.
Finally, a company’s chief risk officer must work
with its chief financial officer to calculate and
monitor the firm’s financial resources. They
must form teams responsible for liquidity risks
in their risk, financial planning, and treasury
divisions. Otherwise, corporations will not
just remain vulnerable to the next financial
virus, they may even exacerbate it, fulfilling
the words of Spanish-born philosopher
George Santayana that “those who do not
remember the past are condemned to repeat it.”
RETHINKING TACTICS
67
REDEFINING INDUSTRIES
A Bankless Future?
The Industrialization of Commodity Trading
Commercial Drones
Self-Driving Freight in the Fast Lane
RISK JOURNAL | VOLUME 5
It is the year 2115 and my great-grandson,
Barrie Wilkinson IV, walks into a real estate
agent’s booth on New York City’s Upper
West Side.
Barrie: “I’m looking for a one-bedroom apartment.
Do you have anything for $20 million or less?”
Real estate agent: “You are in luck, sir. Such
a property came on the market today.”
Barrie: “Can I take a look?”
Real estate agent: “Of course. Put on these
i-goggles and I’ll take you on a virtual tour.”
Five minutes later…
Barrie: “It looks great. I’ll take it.”
Real estate agent: “Wonderful! I’ll just need
you to sign the contract and confirm means
of payment.”
Barrie lifts his arm and starts speaking to
his Apple Watch: “Update on my financial
situation, please.”
Watch: “I’m opening your Amazon money
manager account. You have $3 million in liquid
bonds and $4.5 million in your equity portfolio.”
Barrie: “Liquidate my bond portfolio and set
aside funds for a deposit on the house.”
Watch: “Transaction complete.”
Barrie: “Now I need a mortgage for $17 million.”
Watch: “Your Experian credit rating has expired.
Would you like me to get it renewed?”
Barrie: “Yes. And share all available information
so I get the best possible rating.”
Watch: “Done. You have received a B2 rating.
You now need to upload the information on the
property and legal documents. You have received
five mortgage offers. How should I rank them?”
Barrie: “By price please, and filter for offers that
cannot deliver the funds today.”
Watch: “The best offer is from Vodafone Finance
at 2 percent for a 30-year fixed-rate mortgage.
Would you like to proceed?”
Barrie: “Yes, that sounds great.”
Watch: “I can confirm that the mortgage
funds have been transferred to a custodial
account awaiting confirmation of receipt of the
property deeds.”
Real estate agent: “I just need a fingerprint
signature on the contracts, and I’ll release
the deeds.”
Barrie presses his finger on the screen of
his watch.
Real estate agent: “Excellent. Here are the keys
to your new home. Congratulations.”
A BANKLESS FUTURE? BRACING FOR THE UNBUNDLING OF BANKS
Barrie Wilkinson
REDEFINING INDUSTRIES
71
UNBUNDLING BANKS
While it may seem unlikely, the scenario above
is already possible using technology currently
in existence. Most readers will be struck by how
quick and hassle-free buying a house could
technically become. But bankers should be
struck by something else: Namely, the absence
of any party in the story that resembles the
banks of today. Each activity involved in
the financing of Barrie IV’s house purchase
is performed by a separate firm. When his
great-grandfather recently bought a house,
they were all performed by one bank.
Fintech firms are already using advanced
information technology to compete with banks
in various parts of their “value chain.” Thus
far, the competition has been restricted mainly
to the payments space, but they are moving
into other areas. Investors are enthusiastic
about their prospects.
Tens of thousands of bank employees spend
their days concerned with credit risk, market
risk, cybersecurity, and a plethora of other
menaces. Yet these threats are trivial compared
to the prospect of being rendered irrelevant
by technology.
Is the multi-function, one-stop-shop banking
model doomed?
To answer the question, we need to look
at what banks do. Is there any function
performed by banks that couldn’t be done
better by stand-alone competitors using new
technology? Or is there some advantage
in combining these activities within a
single firm?
Banks need to adopt much of the technology used by their upstart competitors
Denys Prykhodov / Shutterstock.com
RISK JOURNAL | VOLUME 5
72
ExhIBIT 1: UNBUNDLING BANKS
TRADITIONAL BANK (ONE-STOP-SHOP FOR ALL BANKING SERVICES)
AFTER UNBUNDLING
Customers
Customers
4. PAYMENTS
4. “PAYMENT PROVIDERS”
1. DEPOSIT GATHERING3. LENDING/UNDERWRITING/CREDIT ASSESSMENT
3B. CREDIT RATING“RATING AGENCIES”
2. MATURITY TRANSFORMATION“TREASURY SERVICES”
ASSETS
Term money
Liquidity buffer
LIABILITIES
Equity
Money market(short-term)
deposits
1. DEPOSIT GATHERING“MONEY MARKET FUND”
ASSETS
Money market deposits
Highly liquid bonds
LIABILITIES
Equity
Deposits
3A. LENDING/CREDIT UNDERWRITING
“LOAN FUND (SPV)”
ASSETS
Loans
LIABILITIES
Mezzanine debt
Equity
Senior debt
Debt
Equity
Deposits
LIABILITIES
Loans
ASSETS
2. MATURITYTRANSFORMATION
Experian/FICO S&P/Moody’s/Fitch
Loan customer
rating
Senior debt
rating
CustomerData
CustomerData
Information flowMoney flow
Source: Oliver Wyman Analysis
REDEFINING INDUSTRIES
73
ThE RISE OF PURE‑PLAY PROVIDERS
Banking involves four basic activities: deposit
taking, maturity transformation (using
short-term liabilities to fund long-term assets),
lending (including credit assessment), and the
provision of payments. These activities have
traditionally been bundled together in a single
firm. But they need not be. Each function could
instead be performed by pure-play providers.
(See Exhibit 1.)
Some such pure-play firms already exist.
Non-bank payments providers, such as PayPal,
are familiar and growing in number. In an
unbundled world, they could extend their
activities to include direct debits, standing
orders, and other payments still dominated
by banks.
Today’s money market funds resemble the
pure deposit takers. Though they must
invest to pay interest to their depositors,
they greatly reduce the risk of doing so by
buying only high-rated, liquid securities in an
unlevered model.
Loan funds and securitization vehicles already
resemble pure-play lenders. They fund
their lending by issuing securities backed
by the loan assets. In a mirror image of money
market funds, they reduce the liability side
of their business to a formality. And, of
Banks will continue to lose big chunks of what they do now
course, stand-alone credit assessors, such as
Experian and Moody’s, have been around
for decades.
The notable exception is maturity
transformation. No firm provides maturity
transformation as a stand-alone service,
taking the short-term assets of investors and
providing lenders with long-term funding.
how come?
MITIGATING DEPOSITOR RISKS
In his seminal 1937 paper “The Nature of the
Firm,” British Nobel Prize-winning economist
Ronald Coase argued that the scope of a firm’s
activities is determined by transaction costs. A
firm will buy from an external supplier unless
transaction costs make it cheaper to do things
in-house. These transaction costs arise mainly
from contractual uncertainty and the difficulty
of getting information.
Standardized contracts in financial markets
(most notably, for exchange-traded securities)
and advances in information technology have
dramatically reduced market and transaction
costs. So we should not be surprised by the
emerging unbundling of banks.
But what about maturity transformation?
Why haven’t external providers emerged
when the transactions required have also
become cheaper?
The answer is government policy.
Maturity transformation creates a risk for
depositors. If too many depositors ask for
their money at once, the bank (or an alternate
provider) may not be able to hand it over
because it cannot liquidate its long-term
assets. To protect depositors from this risk,
and the economy from the systemic risk
created by bank runs, governments now
RISK JOURNAL | VOLUME 5
74
guarantee retail bank deposits. Emergency
access to central bank support also helps banks
to mitigate the risk of a run on wholesale
deposits. These mechanisms effectively, if
unintentionally, subsidize the short-term
borrowing performed by deposit-taking
institutions. Unsubsidized pure-play providers
cannot compete.
Of course, governments attempt to reduce
the extent of this subsidy by requiring deposit
takers to hold liquid assets sufficient to prevent
the need to call upon these mechanisms.
But the non-existence of pure-play providers
suggests that this is insufficient to eliminate
the subsidy.
REVAMPING BANKSSo long as these implicit subsidies are worth
more than the burden of liquidity and capital
rules, banks are unlikely to completely unbundle
in the way envisaged above. But they will
continue to lose big chunks of what they now
do. And in response, they will find themselves
adopting much of the technology of their
upstart competitors.
There will probably still be banks around when
my great-grandson begins to look for a London
residence, but they will not exist in the same
form that we know them today. And, as Barrie IV
will testify, banking will be better than we now
know it, whoever supplies it.
Barrie Wilkinson is a London-based partner and co-head of Oliver Wyman’s Finance & Risk practice in Europe, Middle East, and Africa.
REDEFINING INDUSTRIES
75
ThE INDUSTRIALIZATION OF COMMODITY TRADING WHAT ASSET-BACKED TRADERS’ STRONG RESULTS MEAN FOR THE FUTURE OF INDEPENDENT TRADERS
Alexander Franke • Ernst Frankl • Christian Lins • Adam Perkins Roland Rechtsteiner • Graham Sharp
One after another, the commodity
trading industry’s traditionally
leading independent traders have
been increasingly stagnating as the prices of
everything from copper to crude oil remain
stuck at rock-bottom levels. By contrast, the
world’s slow-moving top asset-backed trading
giants are announcing rock-solid results.
has the commodity trading industry been
turned on its head? No, but the turnabout
shows that it’s obeying a new set of rules – a
seeming contradiction that only makes sense
in light of an ongoing transformation of
nonconformist commodity trading into a
mature industry. The strong trading results of
longstanding oil majors and other asset-backed
traders provide a glimpse into the potential
of strategies that will work in the future. The
commodity traders that have come closest to
achieving established, institutionalized global
machines designed to generate earnings
reliably in spite of market conditions are now
at the head of the pack.
The trailblazers in the commodity world,
in short, are industrializing. Oversupplied
markets, rising customer expectations,
and higher costs resulting from tighter
governance, reporting, and asset management
requirements are fracturing the principles
of commodity trading that once ruled the
industry. Among the casualties: Superstar
commodity-trading individuals accustomed
to operating solo. The new rules require more
than ingenuity, agility, and speed. They call
for systematically achieving superstar results
by transforming market and competitor
intelligence gathered from personal networks
into tradable institutional knowledge, offering
structured customer solutions, and monetizing
“optionality” – defined as the options available
to run, manage, and extract the most value
from their portfolios globally. Leading players
are metamorphosing into light-footed,
one-stop shops able to finance, store,
transport, refine, and distribute commodities
globally with machine-like efficiency, avoiding
operational or financial strain.
REDEFINING INDUSTRIES
77
INSTITUTIONALIZING OPERATIONS
For now, major energy companies and other
asset-backed traders are the furthest along this
path. For example, in the first three months of
2015, BP’s profit fell only 20 percent compared
to the same period in the previous year, even
though crude oil prices were cut in half.
Similarly, the trading arms of Total and Shell
helped to support their overall group results
by taking advantage of favorable forward
market conditions and storage capacity along
their logistics chains. As a group, top-tier
asset-backed traders have been growing their
gross margins more than three times as fast as
independent traders since the financial crisis.
The top five asset-backed trading giants have
bounced back strongly from the crisis, growing
their gross margins as a group by more than
ExhIBIT 1: ThE COMMODITY TRADING GAP
TOP ASSET‑BACKED TRADERS WITh MORE INSTITUTIONALIZED OPERATIONS hAVE GAINED SIGNIFICANT MARKET ShARE AFTER ThE FINANCIAL CRISIS COMPARED TO ThEIR INDEPENDENT TRADING PEERS
US$ BILLIONSMARKET SHARES IN PERCENT
COMMODITY TRADING POST FINANCIAL CRISIS GROSS MARGINS OVERALL AND BY PLAYER
Top five independent traders
Top five asset-backed traders
Other players
Banks
GROWTH2010-2014
-10%
+15%total
0%
+20%
+85%
2010
38
16%
22%
19%
43%
2011
40
35%
22%
22%
21%
2012
40
36%
21%
25%
18%
2013
39
34%
17%
25%
24%
2014
44
35%
17%
23%
25%
Note: Top five = five largest players in 2014 Source: Oliver Wyman analysis
15 percent every year ever since 2010. By
contrast, the gross margins of the top five
independent traders have expanded annually
by only 5 percent. (See Exhibit 1.)
As a result, tightly run, independent traders
are, in a rare shift of industry dynamics,
following the example of asset-backed traders,
rather than the other way around. Independent
traders are striving to institutionalize their
operations without sacrificing their nimbleness
and entrepreneurial drive. To that end, they are
introducing middle-management positions to
break down the organization’s dependence on
a handful of key individuals in order to gather
and act quickly on market intelligence from
anywhere in the world.
At the same time, they are shifting towards a
more rules-based, management-run model,
with explicitly defined delegations of authority
RISK JOURNAL | VOLUME 5
78
and institutionalized processes around
investment decision making and capital
allocation. Many are also building out their
corporate functions, such as corporate finance,
strategy, and external communications. They
are even involving their compliance and
legal departments more in complex issues
such as customer relationships. Some are
going as far as to outsource and offshore
routine administrative work and to publish
comprehensive annual reports.
Of course, no single playbook works for every
player. Established commodity producers
and other asset-backed traders are presently
demonstrating greater resilience to difficult
market conditions by centralizing supply and
trading operations to optimize the returns from
their massive global portfolios of production,
processing, logistics, and retail assets, as
we predicted in “The Dawn of a New Order
in Commodity Trading” Acts II and III, which
appeared in the Oliver Wyman Risk Journal in
2013 and 2014.
At the other end of the spectrum, many
top independent traders are developing
standardized tool kits to invest along
their logistics chains in storage terminals,
transportation, domestic distribution, and
retail chains with a broad network of customers
and partners. In recent months, Castleton
Commodities International, backed by private
investment vehicles and family trusts, bought
Morgan Stanley’s oil business for an estimated
$1 billion. Through subsidiaries, Vitol and
Trafigura partnered with private equity and
sovereign funds to expand into retail fuel
distribution networks and gain control over
transportation and storage assets. A Japanese
trading firm joined with three Japanese
oil-refining companies to form a new liquefied
petroleum gas trader called Gyxis.
For most companies, the commodity-trading
makeover underway requires attaining
significant scale and sophistication, while
not jeopardizing flexibility. Traders scramble
to develop scope through capital-efficient
partnerships and contracts and then seek to
differentiate their services to avoid becoming
commoditized themselves.
That’s why commodity traders with a narrow
commodity or regional footprint are rapidly
expanding and forging closer relationships
with customers. For instance, more
midsize players active in trading only a few
commodities are developing comprehensive,
global cross-commodity portfolios and are
broadening their offerings to counterparties
in order to form longer-term relationships. A
new wave of petrochemical companies is also
building out trading capabilities in related
commodities or service offerings.
3xHow much faster top-tier
asset-backed traders have been growing their gross margins
compared with independent traders over the past five years
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RAISING ThE BARFor companies struggling to adapt, the
industry’s coming of age is problematic.
Consider: The revenues from investment
banks’ commodity trading operations, many
of which were forced to sell their physical
assets and were ultimately sold off, have
stagnated over the past five years. Most niche
players lacking scale and sophistication have
shrunk. For example, commodity hedge funds
primarily betting on price directions without
assets suffered massive capital outflows over
the period.
In general, the industry’s greater scale and
sophistication raises the bar, both for those
existing traders seeking to grow and for those
companies considering entering commodity
trading. New entrants’ resolve is being tested
as never before, especially as commodity
prices remain flat in the near term.
Successful strategists are designing large
systems and industrialized platforms that can
maintain the high degree of entrepreneurship
and individual talent required for them to act
swiftly on monetizing opportunities. hence the
question becomes: Will independent traders
industrialize to the degree required to continue
to take on established top-tier asset-backed
traders as they have done in the past? And if
independent commodity traders improve their
Independent traders are suddenly imitating asset-backed traders, rather than the other way around
resilience, will asset-backed traders be able
to go on building out their capabilities and
gaining market share at the same pace?
To be sure, while the current industry shift
underway is significant, independent
commodity traders have a solid track record
of being able to not just meet, but also to
exceed the industry’s challenges. Still, the
answer depends on whether players can
recognize – and pull – the three key levers
that have led to the exceptional growth and
profitability of top-tier asset-backed traders in
recent years. Those organizations approaching
the large-scale change underway as three
simultaneous and parallel challenges – the
industrialization of processes, the monetization
of interconnected analytics, and the
mass-customization of customer solutions
through partnerships – have a greater chance
of succeeding in this undertaking.
1. Industrializing processes. One of the
biggest challenges for commodity traders
is that the pace at which they have amassed
massive global portfolios of commodities
and logistics and retail operations in recent
years has outpaced the investment in
processes that are needed to monetize
their potential effectively. This is especially
true for independent traders that have
historically had an appetite for more
complex deals, which require extensive
oversight by their own staff and as a
result cannot be easily integrated into a
standardized trading workflow.
Consequently, the more commodity traders
attempt to be all things to all clients, the
more their costs rise – often faster than their
revenues. Commodity traders are trading a
much broader range of commodities with
more numerous counterparties, handling
more complex logistics chains, managing
more multifaceted financial and operational
risks, and delivering commodities to
wholesale and retail customers in smaller lot
sizes around the world.
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To avoid this outcome, major energy
companies have been refining their
ability to incorporate their longstanding
operational expertise into their trading
divisions’ cultures. They are standardizing,
automating, and outsourcing processes.
They are breaking down barriers between
logistics operations and their supply and
trading divisions in order to improve
operational stability and efficiency. At the
same time, they are standardizing and
outsourcing finance, risk reporting, and
post-trade handling matters.
Taken together as a whole, these efforts are
having a significant impact. One leading
asset-backed player, for example, was
able to reduce the ratio of costs to trading
income by more than 10 percentage points
simply by standardizing and outsourcing
more work.
2. Monetizing interconnected analytics.Leading asset-backed traders are also
developing a competitive edge in terms
of automating the collection and analysis of
their market intelligence in order to optimize
the value captured from existing strategies
and to develop entirely new opportunities.
Traditionally, commodity traders have
gathered market intelligence from personal
networks of buyers, sellers, shippers, and
agents with little formalized assessment and
tracking. Centrally controlled fundamental
market analytics have been critical, but
these have often struggled to support
fast-paced day-to-day front-office decisions.
But that’s beginning to change.
Leading traders are breaking down their
organization’s heavy dependence on a
handful of key individuals for critical decision
making across global systems based on
market intelligence.
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They are strengthening their market, weather,
and competitive intelligence-gathering
capabilities by upgrading their systems
to process the Big Data that exists across
their massive operations. They are adopting
remote-sensing technologies such as
satellites and ground-based sensors to
gather quasi-real-time market intelligence
on waterborne vessels and pipeline flows,
as well as the state of refineries, stockpiles,
and tank farms worldwide.
By connecting their proprietary
intelligence on flows, the condition of
their assets, and competitor behavior
with new technology-backed market and
competitor intelligence, leading traders
are able to improve the precision of their
trading strategies, as well as identify new
opportunities. To be sure, intelligence
gathered by individuals will always be
hugely important to the commodity
trading industry. But the new front line for
competition between commodity traders
is shifting toward inferring meaningful
intelligence in a timely manner from a
combination of proprietary intelligence and
ground or remote sensing data from other
sources. This can be achieved with so-called
“smart machine” algorithms that learn to
derive signals to trade by identifying patterns
and anomalies.
3. Developing equity‑based opportunities. Top asset-backed traders are also beginning
to play catch-up with leading independent
commodity traders by successfully building
out their business development and
origination capabilities. In the past, top
asset-backed traders have been slower
than independent traders such as Vitol
and Trafigura to strike capital-efficient
partnerships in order to expand their
capabilities and market access. That’s in
large part because they didn’t have to.
Most oil majors and other large commodity
producers were already operating in most
of the key markets and were able to mobilize
resources globally more easily because of
their already existent vast global production
and processing networks.
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Alexander Franke is a Zurich-based partner, Ernst Frankl is a Frankfurt-based partner, Christian Lins is a Zurich-based engagement manager, Adam Perkins is a London-based engagement manager, and Roland Rechtsteiner is a Zurich-based partner in Oliver Wyman’s Energy practice. Graham Sharp is a co-founder of Trafigura and a senior advisor to Oliver Wyman.
But recently, asset-backed players have
been entering partnerships in new
markets to exploit profitable niches and
emerging markets, especially in the
Eastern hemisphere. For example, Shell has
been involved in a number of successful
collaborations with logistics-services
provider Royal Vopak N.V. related to
infrastructure investments. BP is joining
forces with Sinopec to gain access to the
Chinese bunker fuel market. European
utility traders are also considering Asian
partnerships in order to expand and better
optimize their global fuel and freight books.
Other traders are also entering deals backed
by third-party master agreements with
banking, logistics, project development,
and engineering partners. They have
discovered that these partnerships serve a
dual purpose. They help their companies
to avoid becoming slow and rigid in their
quest for stability. At the same time, traders
pick up clear guidance on complementary
commodity classes, potential acquisition
targets, and preferable deal structures.
BREAKING FROM ThE PACK
The commodity-trading industry began as
a fragmented band of individuals stepping
in to smooth out global supply and demand
imbalances and information asymmetries.
But that’s not where it will end. To remain
front-runners, commodity traders must
industrialize in order to become nimble, global
one-stop-shops for multiple commodities, in
addition to providing for their financing, risk
management, and logistics.
To do so, in the next five years, commodity
traders will morph into organizations with all
of the benefits and challenges of other mature
industries. Like automakers, manufacturers,
and financial-services firms before them, as
commodity traders’ business models become
increasingly homogeneous, they will be under
even more intense pressure to distinguish
themselves from the pack.
This is a tall order for an industry made up of
creative and nimble customers and key trading
talent unaccustomed to more institutionalized
cultures. Sluggish commodity markets and
slipping trading margins could threaten
traditional compensation structures and levels.
Nevertheless, leading independent traders
must learn from asset-backed traders in order
to grow and become more resilient. If the past
is an indicator for the future, independent
players will find nimble and swift ways to adapt
and lead again. Conversely, asset-backed
traders will need to continue to push the
envelope in professionalizing the industry
and strive to be more agile by exploring new,
innovative ways to inexpensively optimize all
of the options available in their massive global
operations. No one can afford to sit still.
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COMMERCIAL DRONES THE UNITED STATES MUST SPEED UP GLOBALLY COMPETITIVE REGULATIONS
Georges Aoude • Peter Fuchs • Geoff Murray
By 2035, the number of unmanned
aerial vehicles in operation in the
United States is expected to surpass
the number of manned aircraft in operation.
The US commercial drone market could easily
be worth $5 billion, according to the Volpe
National Transportation Systems Center, and
the global commercial market may be several
times greater.
Although the use of drones is relatively novel
in the US, that is not the case with other
developed countries. In Japan, for example,
farmers have been using drones for decades
to inspect crops. In Canada, police use
drones for search-and-rescue operations.
In the United Kingdom, drones are used for
commercial photography. Yet in the US, such
activities have been relatively rare because
the Federal Aviation Administration (FAA)
considers commercial drone usage illegal
without special permission.
This past February, the FAA finally proposed
regulations for commercial drones. Once the
rules are finalized, the hope is that within a
couple of years the US will be on par with many
other countries. Already, the FAA has begun
granting more exemptions for commercial
drones, as well as blanket waivers for certain
operators. (See Exhibit 1.) The US needs to
continue to close its gap with other nations,
or it risks leaving billions of dollars in economic
growth on the table as drone service providers
and customers take their business elsewhere.
TAKING ThE LEAD
It is not too late for the US to take the
lead. With more reasonable and globally
competitive regulations, the US could still
become a front-runner in this fast-changing,
growing industry. The FAA is moving in the
right direction by beginning to base rules on
the actual risk that small, unmanned aircraft
pose to the public. But the administration
must go further. It’s important for the FAA to
develop the risk-based foundation for drone
regulations – not just for the purpose of
unleashing the US market but to guide that
more heavily fraught regulatory issue: privacy.
The rationale for the distinction between
recreational and commercial drone activities
mirrors the manned aircraft world, where
commercial pilots are responsible for
transporting large numbers of passengers
safely in large aircraft and are held to the
highest level of experience and training.
Recreational pilots are held to a lower
standard in terms of experience because of
the lesser potential for harm to life and damage
to property. however, there is little difference
whether smaller drones are used for commercial
or recreational purposes, as the risks they
pose are similar. In both cases, the drones are
unmanned, and the risk of damage to people,
property, or manned aircraft is low.
After struggling with this and other issues, the
FAA found that the manned aircraft framework
cannot be readily applied to commercial
drones. For example, the agency dropped the
idea of requiring drone operators to hold
pilot licenses.
2035The year that unmanned aerial
vehicles in operation in the United States should surpass the
number of manned aircraft
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This is the same lesson that regulators in
other countries have learned. The technology
is moving too quickly; the field to be regulated
is too new. Lower risk activities must be
permitted sooner rather than later; incremental
regulations must be released when ready, and
then improved, so that the technology can be
introduced safely as soon as is practical.
IMPROVED RISK ANALYSIS
Still, the process is far from perfect, as a
recent spate of near misses with unauthorized
drones in US airspace shows. Regulators’ use of
risk-based language is not always accompanied
by a serious risk analysis and ranking of
different types of drone operations. For
example, how can the FAA justify stricter safety
requirements for commercial drones than for
recreational drones, when both involve exactly
the same operations, unless the answer is
simply that the law requires it?
ExhIBIT 1: GLOBAL COMMERCIAL DRONES: ThE RACE IS ON
ThE NUMBER OF REGISTERED COMMERCIAL DRONE OPERATORS IS RAPIDLY INCREASING WORLDWIDE
3,000 2,500 2,000 1,500 1,000 500
Japan
France
United States
United Kingdom
Australia
0
Source: Government data through August, Oliver Wyman analysis
Many countries distinguish instead between
heavier drones (typically, those weighing
more than 55 pounds) and lighter drones. The
smallest drones, weighing less than 4.4 pounds,
are treated differently in some countries because
they pose a much lower safety risk than larger
drones. Most commercial drones weigh far less
than 55 pounds and operate below
commercial airspace.
The technology poses other conundrums for
regulators to assess risk. For example, drones
rely on shared, non-secure radio frequencies,
and the radio link between the drone and its
ground-based operator can be interrupted.
Regulators worry about what could happen
in the event of an interruption. Some drone
manufacturers are addressing this issue by
programming their drones to hover while
waiting for the link to be re-established and
to return to home base after a set period if a
secure link is not re-established. Regulators and
manufacturers continue to study solutions
to the lost link issue.
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The proposed FAA regulations conclude that
even the smallest, lightest drones, those
under 4.4 pounds, traveling beyond the line
of sight of the operator (which would likely
be the case in commercial operations) entail
greater risk than heavier drones within the
line of sight. But what is the true safety risk
profile of different alternative operations under
consideration? This rule would leave some
highly anticipated activities, like package
delivery, out of bounds.
DEVELOPING A TIERED SYSTEM
With a few modifications, the current airspace
and regulatory structure may easily lend itself
to drone operations. For example, current
uncontrolled airspace could be approved
for beyond-line-of-sight operations, while
controlled airspace would be reserved to
line-of-sight operations. Similarly, current
regulations defining type of operation,
including visual and instrument flight rules,
could be applied to define when drone
operations may and may not occur. And the
current civil definition of flight operations,
from light sport aircraft to commercial airline
operations, lends itself to a tiered system of
qualifications, regulations, and acceptable risks.
It is difficult to put a price tag on the lost
opportunities in the US market resulting
from regulatory constraints. however, the
Association for Unmanned Vehicle Systems
International estimates that each year of delay
has a $10 billion economic impact for the US.
We expect that once the FAA issues reasonable
regulations, the US drone service providers will
quickly catch up to their foreign competitors.
Still, the first movers in other countries could
achieve important short-term gains. At a
minimum, they gain time to develop their
brands in the market.
To catch up with the global drone industry,
US regulators must stick to their plan of
incremental rule updates that are risk-based
and closely track industry developments.
This groundwork will be important as drone
use becomes more widespread globally, and
the public begins to call for strict privacy
parameters. Typically, activities with lower
safety risks, such as precision agriculture,
oil and gas exploration, and wildlife
conservation, have lower privacy risks
because they are conducted in remote areas.
The most sensitive concern is that people
will use drones for surveillance or to fly over
private property and transmit images. Privacy
concerns will probably prove more difficult
to manage than safety, and already some
local authorities are issuing their own rules.
Some privacy issues will certainly be covered
by existing law, but there may be loopholes
that regulators must catch as drones take to
the skies.
US regulators should embark on a plan to
catch up to global standards for prudent,
risk-based regulations that meet these
challenges. By doing so, the FAA can enable the
safe deployment of new unmanned vehicles in
the US without forcing the private sector to pay
a steep price for its late start.
Georges Aoude is a Dubai-based associate in Oliver Wyman’s Aviation practice. Peter Fuchs is a New York-based principal at Mercer and co-founder of Ascent AeroSystems. Geoff Murray is a Chicago-based partner and Oliver Wyman’s Aerospace sector leader. Mercer, like Oliver Wyman, is a division of Marsh & McLennan Companies.
This story first appeared on Forbes.com.
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SELF‑DRIVING FREIGhT IN ThE FAST LANE DRIVERLESS VEHICLES ARE ABOUT TO REWRITE THE RULES FOR TRANSPORTING NOT JUST PASSENGERS, BUT FREIGHT, TOO
Jason Kuehn • Juergen Reiner
Driverless cars, which are in
development by Google, Tesla,
Apple, and a slew of automakers, are
expected to revolutionize personal transport
in the next decade. Soon, driver-free trucks
and locomotives will become a new economic
imperative for freight railroads and motor
carriers, as well.
Specialized automated trucks are already in
use at off-road and remote locations, such as
mines in Australia and Chile, military bases,
and container terminals. On-road, they are
being tested in the United States and Europe
by Freightliner/Daimler, Volvo, and Peterbilt.
Driverless trucks on open roads will face the
same challenges as driverless cars, although
trucks’ added size and weight are likely to
generate even greater public-safety concerns.
Trains are easier to run in an automated
manner, as they use fixed guideways and
do not have to deal with unpredictable traffic.
Indeed, a number of short-haul mining
operations in North America have used
automated trains since the 1960s. Today,
some 48 city metro systems worldwide are
automated, as are dozens of airport shuttle and
people-mover systems. In the second half of
2015, mining company Rio Tinto is expected
to start up the world’s first long-distance
driverless freight rail service, with 42 trains
operating over 1,000 miles of track in
Western Australia.
So the question is not whether the technology
is feasible for self-driving trains and trucks, but
what the impact will be once it becomes more
widely adopted. Research and development
is much further along in the automation of
trucking than in freight rail, in large part
because trucking is more labor intensive and
the economic benefits of automation greater.
The compelling economics of autonomous
trucking may change the transportation
landscape so radically, however, that railroads
will have no choice but to respond in kind.
To manage this transition safely, all parts of
society – government, the private sector, and
the public – will need to work in concert, with
freight railroads and motor carriers leading
the way.
ECONOMIC IMPACT OF AUTOMATION
A major benefit of driverless trucking
would be its impact on the current and
projected shortage of long-distance drivers
in the United States and Europe. An aging
population, lower wages (in the US, truck
drivers earn only about half of what train
crews do), tighter hours of service rules,
and a younger generation less willing to
spend long periods of time away from
home mean that the US is short as many as
35,000 drivers – and could be short 240,000
by 2023, according to the American Trucking
Association. Some 40 percent of truck drivers
in Germany will retire over the next decade,
as reported by the Wall Street Journal, which
could lead to a shortfall of 250,000 drivers.
Driverless trucks would reduce the demand for
long-distance drivers; most remaining drivers
could then be utilized for more complex local
240,000The anticipated shortfall
of truck drivers in the United States by 2023
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pickup and delivery operations, which would
solve many of the lifestyle issues faced by
truck drivers.
Driverless trucks would yield other economic
benefits as well: Today, trucks sit idle when
drivers are in mandatory rest periods;
autonomous trucks could be kept moving.
This change alone could reduce driver costs
by up to two-thirds and increase equipment
utilization by one-third. having trucks travel
together in a closely spaced “platoon” with a
driver only in the lead vehicle could cut fuel
consumption by up to 10 percent. Accident
rates could drop by up to 70 percent, resulting
in lower casualty claims and likely lower
insurance rates, especially if truck-dedicated
lanes become a reality. Furthermore, it’s
estimated that operating driverless vehicles
with closer spacing and at more consistent
speeds over long distances could increase
highway capacity by 200 percent or more.
While railroads currently are able to fill most
of their train crew jobs due to higher pay
levels versus trucking, the lifestyle similarities
between train crews and truck drivers suggest
that a shortage of train crew personnel
may not be too far away. Automation of
locomotives would decouple work from the
actual movement of trains, enabling operating
support jobs to be converted to regular shift
assignments at fixed geographic locations
and improving the appeal of railroading
to employees who want more consistent
schedules and to work near home.
At the same time, railroads could reduce their
labor costs and boost their network capacity
by running driverless trains. Asset utilization,
service levels, and reliability also could
improve, as they could operate more frequent,
shorter trains at no cost disadvantage versus
current operations – although such a change
will require double-tracking the core network
to enable trains to move in both directions
at once in order to gain the “conveyor belt”
benefits of automation. Such changes are
likely to become necessary if driverless
trucks reduce motor carrier costs enough to
make them competitive with rail over longer
distances. Otherwise, railroads could face a
loss of market share that would be difficult to
make up.
GOING DRIVERLESS: WhAT WILL IT TAKE?
Many of the technological building blocks for
driverless trains already exist (or are being
implemented) in the US and Europe: remote
control systems, onboard computers that
enforce speed limits and regulate movement,
and software that optimizes train operation
and fuel consumption.
The critical barrier at present to driverless trains
is the issue of protection of the right-of-way,
as trains do not have the means to detect and
avoid obstacles in their paths. To overcome
that impediment, several different strategies
in tandem will be needed: Grade crossings
may require upgrades or real-time monitoring
systems to ensure the “box” within the gated
area remains unobstructed. Automobile drivers
will need to be more alert around crossings;
in the US, for example, the Federal Railroad
250,000The anticipated shortfall of truck drivers in Germany by 2025
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90
Administration has partnered with Google
to add all grade crossings to Google Maps.
When the software is used for turn-by-turn
navigation, it will warn drivers when they are
approaching crossings.
With the implementation of positive train
control (PTC), freight trains will be able
to send their locations via satellite to an
accessible database, much like the many
transit systems that already offer tracking apps.
It’s not hard to envision a future of mobile
phones lighting up and beeping loudly to
warn drivers and pedestrians of an oncoming
train in their vicinity, reducing the likelihood
of accidents. (All this would require is that the
phone’s location tracking system be turned on
and that it be running in the background.)
Of course, no rail corridor can be completely
sealed off, which means trains will need
obstacle detection and avoidance systems.
Autonomous cars, for example, will use light
detection and remote sensing technology,
linked to the braking and steering systems, to
avoid obstacles. The major challenge for an
automated train will be determining what the
obstacle in its path is and whether to brake for
it – since sudden deceleration can create a
risk of derailment. Is it a car that can’t get out
of the way – or a deer that can?
For autonomous trucks, the challenge is
somewhat different, and likely greater, given
that trucks operate on open roads with full
public access. Many experts believe that
gaining acceptance for driverless trucks will
mean restricting them initially to dedicated
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ExhIBIT 1: hIGhWAY TO ThE FUTURE: DRIVERLESS ROADS
hOW hIGhWAYS COULD EVOLVE IN RESPONSE TO DRIVER‑FREE VEhICLES
As driverless trucks come online in the next five to 10 years, they may initially be required to operate in segregated lanes. But once the practice becomes widespread, highways may be restricted to autonomous vehicles. While this transition is fraught with risk, it could yield substantial benefits.
Top Five Benefits of implementation • Solve long-haul driver shortage• Increase highway/rail capacity• Reduce costs and increase asset utilization• Reduce accidents and claims• Reduce fuel consumption
Top Five Risks of implementation • Public perception of safety risks• Significant funding requirements• Some technology is still in development• Need for regulatory change• Labor union resistance
TODAYMixed cars and truckswith drivers
IN FIVE TO 10 YEARSSegregated lanes for autonomous trucks (alone or “platooned”with driver in first truck)
IN 10 TO 20 YEARSAll highway tra�cdriverless
Indicates driverless
Indicates driver
Autonomous traffic lanes
Source: Oliver Wyman analysis
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and segregated highway truck lanes. (See
Exhibit 1.) In theory, building such lanes could
be funded by instituting tolls. And while
converting some lanes to autonomous-only
vehicles would likely add to highway capacity
(and thus cut congestion), this could be
a political non-starter unless there are at
least two lanes in each direction (or more, in
heavily congested urban areas) available for
conventional driving.
A reverse solution has been suggested to
restrict conventional vehicles instead to special
toll lanes, as they take up more capacity and
are projected to have higher accident rates
than autonomous vehicles. This might be
an incentive for the more efficient solution;
however, it is unlikely to gain public or political
goodwill until autonomous vehicles become
more widespread.
AUTONOMY: THE NEXT COMPETITIVE EDGEThe technology for driverless trucks and trains
will largely be in place over the next three
to five years, and the economic imperative
will only escalate. Driverless trucking faces
more hurdles, but has more to gain in terms
of solving long-term industry structural
problems. Railroads could face regulatory
and labor union issues, but automation would
be easier to implement from a technology
standpoint. Most critically, failure by the
railroads to move quickly enough could lead
to an erosion of their traffic base, as driverless
trucking would enable motor carriers to
challenge railroads across a much wider swath
of their market.
Jason Kuehn is a Princeton-based vice president in Oliver Wyman’s Transportation practice. Juergen Reiner is a Munich-based partner in Oliver Wyman’s Global Automotive practice.
Steve Lagreca / Shutterstock.com
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THE OLIVER WYMAN ONLINE RETAIL REPORTThis selection of articles explains how existing bricks-and-mortar retailers can resist the loss of revenue to online players and how they can build their own successful online offer.
THE OLIVER WYMAN TRANSPORT & LOGISTICS JOURNAL A publication that discusses issues facing global transportation and logistics industries.
THE PROCUREMENT PLAYBOOKStrategies and plays from 100 chief procurement officers.
WELCOME TO THE HUMAN ERAA new model for building trusting connections, and what brands need to do about it.
THE OLIVER WYMAN RISK JOURNAL, VOL. 4A collection of perspectives on the complex risks that are determining many companies’ futures.
THE PATIENT-TO-CONSUMER REVOLUTIONHow the tech attack radically advances US healthcare – and creates a clear path to market sustainability – by unleashing consumer demand and forever changing the basis of competition.
THE STATE OF FINANCIAL SERVICES 2015Managing complexity: The 18th edition of this annual report explains how financial firms can reduce the costs of complexity while reaping its benefits.
WOMEN IN FINANCIAL SERVICESFrom evolution to revolution: The time is now.
GLOBAL DIRECTORY
AUSTRALIA
SYDNEY+61 2 8864 6555
BERMUDA
hAMILTON+441 297 9737
BRAZIL
SÃO PAULO+55 11 5501 1100
CANADA
MONTREAL+1 514 499 0461
TORONTO+1 416 868 2200
ChINA
BEIJING+86 10 6533 4200
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FRANCE
PARIS+33 1 45 02 30 00
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SINGAPORE
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TROY+1 248 906 7910
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AUTHORS
MARK ABRAHAMSONPrincipalPhone: +44 20 7852 7681Email: [email protected]
GEORGES AOUDEAssociatePhone: +971 4 425 7000Email: [email protected]
RAJ BECTORPartnerPhone: +1 646 364 8519Email: [email protected]
DUNCAN BREWERPrincipalPhone: +44 20 7852 7760 Email: [email protected]
MICHELLE DAISLEYPartnerPhone: +44 20 7852 7812Email: [email protected]
JOHN DRZIKPresident of Global Risk and SpecialtiesMarshPhone: +1 212 345 1220Email: [email protected]
MICHAEL DUANEPartnerPhone: +1 646 364 8764Email: [email protected]
GEORGE FAIGENPartnerPhone: +1 609 510 1202Email: [email protected]
ALEXANDER FRANKEPartnerPhone: +41 44 5533 511Email: [email protected]
ERNST FRANKLPartnerPhone: +49 69 971 73 570Email: [email protected]
PETER FUCHSPartnerPhone: +1 212 345 9175Email: [email protected]
NICK HARRISONPartnerPhone: +44 20 7852 7773Email: [email protected]
BERNHARD HARTMANNPartnerPhone: +971 56 418 5501Email: [email protected]
BILL HEATHPartnerPhone: +44 7713 653 855Email: [email protected]
RISK JOURNAL | VOLUME 5
CLAUS HERBOLZHEIMERPartnerPhone: +49 30 399 94563Email: [email protected]
ROB JESSENPartnerPhone: +1 713 276 8237Email: [email protected]
KEVAN JONESPartnerPhone: +44 7711 113 987Email: [email protected]
DOMINIK KAEFERPrincipalPhone: +49 699 7173470Email: [email protected]
JASON KUEHNVice PresidentPhone: +1 609 520 2545Email: [email protected]
FADY KHAYATTPartnerPhone: +33 1 45 02 36 62Email: [email protected]
CHRISTIAN LINSEngagement ManagerPhone: +41 44 553 35 17Email: [email protected]
SEAN MCGUIREPartnerPhone: +44 207 852 7580Email: [email protected]
SANDRO MELISPartnerPhone: +39 02 3057 7447Email: [email protected]
GEOFF MURRAYPartnerPhone: +1 312 545 9382Email: [email protected]
GEORGE NETHERTONPartnerPhone: +44 790 868 3634Email: [email protected]
BOB ORRPartnerPhone: +1 713 276 2187Email: [email protected]
ROBERT PARISIManaging DirectorMarsh FINPROPhone: +1 212 345 5924Email: [email protected]
ADAM PERKINSEngagement ManagerPhone: +44 20 7852 7439Email: [email protected]
AUTHORS
ROBERT D PETERSONPartnerPhone: +1 469 406 8184Email: [email protected]
ROLAND RECHTSTEINERPartnerPhone: +41 44 5533 405Email: [email protected]
JUERGEN REINERPartnerPhone: +49 175 2905064Email: [email protected]
SAJI SAMPartnerPhone: +971 50 503 0648Email: [email protected]
SIR HECTOR SANTSPartnerPhone: +44 20 7852 7144Email: [email protected]
TIL SCHUERMANNPartnerPhone: +1 646 364 8427Email: [email protected]
GRAHAM SHARPSenior AdvisorPhone: +41 44 5533 264Email: [email protected]
RICHARD SMITH-BINGHAMDirectorMarsh & McLennan Companies Global Risk CenterPhone: +44 20 7852 7828Email: [email protected]
BARRIE WILKINSONPartnerPhone: +44 20 7852 7423Email: [email protected]
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OLIVER WYMAN RISK JOURNAL
EDITORS
JULIA KLEINMarketing DirectorFinancial Services PracticePhone: +44 20 7852 7372Email: [email protected]
EMILY THORNTONDirector of Research Manufacturing, Transportation, and Energy PracticePhone: +1 646 364 8279Email: [email protected]
EDITORIAL BOARD
PARTHA BOSEChief Marketing OfficerOliver Wyman GroupPhone: +1 617 424 3337Email: [email protected]
ROLAND RECHTSTEINERPartnerEnergy PracticePhone: +41 445 533 405Email: [email protected]
BARRIE WILKINSONPartnerFinance & Risk PracticePhone: +44 20 7852 7423Email: [email protected]
ALEX WITTENBERGExecutive DirectorMarsh & McLennan Companies Global Risk CenterPhone: +1 646 364 8440Email: [email protected]
DESIGN (PRINT)
MELISSA UREKSOYDesignerPhone: +1 941 751 5896Email: [email protected]
RISK JOURNAL | VOLUME 5
DIGITAL PRODUCTION
TOM GROPPEDirector of Digital MarketingPhone: +1 212 345 1340Email: [email protected]
ANNA PISKORZDigital Production SpecialistPhone: +48 22 456 4077E-mail: [email protected]
CAROLINE SUNAssociate Business Systems AnalystPhone: +1 212 345 7011Email: [email protected]
Copyright © 2015 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written
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opinions in this report were prepared by Oliver Wyman. This report may not be sold without the written consent of Oliver Wyman.
To read the digital version of the Oliver Wyman Risk Journal, visit
www.oliverwyman.com/risk-journal-vol-5.html
ABOUT OLIVER WYMAN
Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 26 countries, Oliver Wyman combines deep
industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm’s
3,700 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational
performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies
[NYSE: MMC]. For more information, visit www.oliverwyman.com. Follow Oliver Wyman on Twitter @OliverWyman.
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